Definitions of FIFO and LIFO
FIFO and LIFO are two of the cost flow assumptions used by U.S. companies with inventory items.
FIFO moves the first/oldest costs from inventory and reports them as the cost of goods sold and leaves the last/more recent costs in inventory.
LIFO moves the latest/more recent costs from inventory and reports them as the cost of goods sold and leaves the first/oldest costs in inventory.
A U.S. company may switch from FIFO to LIFO. However, after the switch the company must use LIFO consistently.
Reason for Using FIFO Instead of LIFO
If a U.S. corporation’s cost of inventory items are continuously increasing and the corporation has been experiencing operating losses and negative taxable income, the use of FIFO means matching its oldest/lower costs with its current sales. The result is a larger gross profit and a positive operating income.
Reason for Using LIFO
If a U.S. corporation’s costs of inventory items are continuously increasing, a profitable U.S. corporation will have lower income tax payments with LIFO. This results from matching the most recent higher costs of its items to the most recent sales. (The higher cost of goods sold means lower net income and lower taxable income than FIFO.)
Another reason for a company to use the LIFO cost flow assumption is to improve the matching of costs with sales. If the company had matched the old low costs using FIFO, the company would show a greater profit that was partly caused by merely holding some old inventory items.
FAQs
Reason for Using LIFO
Why would a company use LIFO instead of FIFO? ›
During times of rising prices, companies may find it beneficial to use LIFO cost accounting over FIFO. Under LIFO, firms can save on taxes as well as better match their revenue to their latest costs when prices are rising.
Why might companies prefer LIFO over FIFO in periods of rising prices? ›
Net income – Similarly, LIFO leads to lower net income versus FIFO in times of inflation or rising inventory expenses. Cash flow – Lower net income under LIFO reduces income tax obligations, leaving more operating cash flow for the business.
What is the primary reason most companies choose LIFO? ›
LIFO Can Lower a Company's Taxable Income
When newer products purchased at a higher rate are sold first, COGS rates rise, and profit margins shrink. This reduces your net income and, in turn, your business's tax liability.
For what purpose does a company use LIFO? ›
Key Takeaways. Last in, first out (LIFO) is a method used to account for inventory. Under LIFO, the costs of the most recent products purchased (or produced) are the first to be expensed.
What are the advantages of LIFO? ›
As we explained in the previous section, the LIFO method's primary advantage is that it allows firms to lower their profits in an inflationary situation. There's another advantage, as well. The LIFO method allows companies operating in an inflationary situation to reflect costs more accurately.
Why would a company switch to the LIFO method of inventory valuation? ›
Advantages Of Using The LIFO Method
In the U.S., LIFO is sometimes used for tax purposes because of inflation. When prices rise, LIFO gives you the highest cost of goods sold with the lowest taxable income. Valuing your LIFO ending inventory is easier than FIFO because you use your most recent costs.
Why is LIFO better during inflation? ›
When inflation increases the value of inventory items sold, LIFO allows those higher costs to be reported on the current year's tax return, thereby increasing the COGS amount and reducing taxable income. Another benefit of LIFO is the ability to match current costs with current revenue.
Which is an advantage of using the LIFO inventory in periods of rising prices? ›
LIFO can lead to lower cost of goods sold (COGS) during inflation. LIFO can result in lower taxable income in times of inflation because it matches higher current prices with current sales, thereby reducing reported profits and tax liabilities.
Why do more retailers use LIFO? ›
Assuming your inventory costs generally increase over time, LIFO offers a definite tax advantage over other inventory reporting methods. By allocating the most recent — and, therefore, higher — costs first, LIFO maximizes your cost of goods sold, which minimizes your taxable income.
Of course, the assumption is that prices are steadily rising, so the most recently-purchased inventory will also be the highest cost. That means that higher costs will yield lower profits, and, therefore, lower taxable income. And that is the only reason a company would opt to use the LIFO method.
What is one of the principal reasons for selecting the LIFO? ›
One of the principal reasons for selecting the LIFO cost flow assumption instead of the FIFO cost flow assumption in an inflationary economic environment is that: income taxes will be lower.
What is the primary reason for popularity of LIFO? ›
Provides better matching of physical flow and cost flow.
Why do companies use LIFO instead of FIFO? ›
In terms of tax purposes, FIFO usually results in a higher tax bill because the inventory that is sold first is usually the most expensive. US companies may prefer LIFO when prices rise because it gives them the highest cost of goods sold and the lowest taxable income.
Why do companies use LIFO reserve? ›
The reason for using the LIFO reserve is because most businesses use FIFO for internal use but LIFO for external reporting. FIFO shows attractive returns to investors whereas LIFO reduces taxes due to the specific calculations of each method. A company's LIFO reserve = (FIFO inventory) - (LIFO inventory).
Why don t more companies use LIFO? ›
IFRS prohibits LIFO due to potential distortions it may have on a company's profitability and financial statements. For example, LIFO can understate a company's earnings for the purposes of keeping taxable income low. It can also result in inventory valuations that are outdated and obsolete.
Why LIFO is not recommended? ›
LIFO understates profits for the purposes of minimizing taxable income, results in outdated and obsolete inventory numbers, and can create opportunities for management to manipulate earnings through a LIFO liquidation. Due to these concerns, LIFO is prohibited under IFRS.
When a company uses LIFO for external reporting purposes and FIFO? ›
When a company uses LIFO for external reporting purposes and FIFO for internal reporting purposes, an Allowance to Reduce Inventory to LIFO account is used. This account should be reported: on the balance sheet in the Current Assets section.
Why does Target use LIFO? ›
This is done to insure that the numbers are as conservative as possible. LIFO values Target's Cost of Goods Sold (COGS) higher than the other inventory accounting methods (FIFO and Average Cost) therefore Net Income is lower with LIFO than with any other method.
