Basics of LIFO and FIFO Inventory Accounting Methods

Overview of Two Methods of Inventory Accounting

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LIFO ("last-in-first-out") and FIFO ("first-in-first-out") are the two most common inventory accounting methods. The method of inventory accounting a small business chooses can directly impact its balance sheet, income statement, and statement of cash flows. Not only do companies have to track the number of items sold, but they have to track the cost of each item. These two methods both have a different effect on a company's financial statements.

To understand this, consider how inventory is determined.

How Ending Inventory Is Determined

Inventory can be broken down into three categories: raw materials, work-in-process, and finished goods. Raw materials are inventory used to produce assets for sale. Work-in-process includes assets in production for sale. Finished goods are assets intended for sale. The inventory equation is: 

Beginning Inventory + Net Purchases - Cost of Goods Sold = Ending Inventory​

The two common ways of valuing this inventory, LIFO and FIFO, can give significantly different results. 

Last-In, First-Out (LIFO)

LIFO assumes that the last items put on the shelf are the first items sold. Last-in, first-out is a good system to use when your products are not perishable or at risk of quickly becoming obsolete. Under LIFO, when prices rise, the higher priced items are sold first and the lower priced products are left in inventory.

This increases a company's cost of goods sold and lowers its net income, both of which reduce the company's tax liability.

This inventory accounting method seldom approximates replacement costs for inventory, which is one of its drawbacks. In addition, it may not correspond to the actual physical flow of goods.

Let's use the gasoline industry as an example. Let's say that a tanker truck delivers 2,000 gallons of gasoline to Henry's Service Station on Monday and the price at that time is $2.35/gallon. On Tuesday, the price of gasoline has gone up and the tanker truck delivers 2,000 more gallons at a price of $2.50/gallon. Under LIFO, the gasoline station would assign the $2.50/gallon gasoline to Cost of Goods Sold and the remaining $2.35/gallon gasoline would be used to calculate the value of ending inventory at the end of the accounting period.

First-In, First-Out (FIFO)

FIFO, on the other hand, assumes that the first items put on the shelf are the first items sold, so your oldest goods are sold first. This system is generally used by companies whose inventory is perishable or subject to quick obsolescence. If prices go up, FIFO will give you a lower cost of goods sold because you are using your older, cheaper goods first. Your bottom line will look better to your banker and investors, but your tax liability will be higher because you have a higher profit. Because FIFO represents the cost of recent purchases, it usually more accurately reflects replacement costs.

Going back to the gasoline industry example, under FIFO, the gasoline station would assign the $2.35/gallon gasoline to Cost of Goods Sold and the remaining $2.50/gallon gasoline would be used to calculate the value of ending inventory at the end of the accounting period.

Financial Statement Problems with LIFO

If your company begins selling inventory faster than it replaces it, LIFO accounting can produce a mathematical outcome that no longer accurately represents what's going on in the real world. 

When you're using LIFO accounting methods in the context of an inventory decline, your balance sheet will soon bear little relation to your actual financial position because your latest costs become the supposed real costs of the goods sold. But as inventory declines, you begin selling goods that were actually acquired for far less at some earlier time. These earlier costs are still there in the inventory account. The result is that the reported asset balance has no relation to the cost of goods at current prices.

Inventory accounting is only one part of a company's management of their inventory investment, but an important one.