FIFO and LIFO accounting methods are used for determining the value of unsold inventory, the cost of goods sold and other transactions like stock repurchases that need to be reported at the end of the accounting period. FIFO stands for First In, First Out, which means the goods that are unsold are the ones that were most recently added to the inventory. Conversely, LIFO is Last In, First Out, which means goods most recently added to the inventory are sold first so the unsold goods are ones that were added to the inventory the earliest. LIFO accounting is not permitted by the IFRS standards so it is less popular. It does, however, allow the inventory valuation to be lower in inflationary times.
|Stands for||First in, first out||Last in, first out|
|Unsold inventory||Unsold inventory comprises goods acquired most recently.||Unsold inventory comprises the earliest acquired goods.|
|Restrictions||There are no GAAP or IFRS restrictions for using FIFO; both allow this accounting method to be used.||IFRS does not allow using LIFO for accounting.|
|Effect of Inflation||If costs are increasing, the items acquired first were cheaper. This decreases the cost of goods sold (COGS) under FIFO and increases profit. The income tax is larger. Value of unsold inventory is also higher.||If costs are increasing, then recently acquired items are more expensive. This increases the cost of goods sold (COGS) under LIFO and decreases the net profit. The income tax is smaller. Value of unsold inventory is lower.|
|Effect of Deflation||Converse to the inflation scenario, accounting profit (and therefore tax) is lower using FIFO in a deflationary period. Value of unsold inventory, is lower.||Using LIFO for a deflationary period results in both accounting profit and value of unsold inventory being higher.|
|Record keeping||Since oldest items are sold first, the number of records to be maintained decreases.||Since newest items are sold first, the oldest items may remain in the inventory for many years. This increases the number of records to be maintained.|
|Fluctuations||Only the newest items remain in the inventory and the cost is more recent. Hence, there is no unusual increase or decrease in cost of goods sold.||Goods from number of years ago may remain in the inventory. Selling them may result in reporting unusual increase or decrease in cost of goods.|
What it means
FIFO stands for First In First Out and is an inventory costing method where goods placed first in an inventory are sold first. Recently-placed goods that are unsold remain in the inventory at the end of the year.
LIFO stands for Last In First Out. It is an inventory costing method where the goods placed last in an inventory are sold first. The goods placed first in the inventory remain in the inventory at the end of the year.
Example of FIFO and LIFO accounting
While this example is for inventory costing and calculating cost of goods sold (COGS), the concepts remain the same and can be applied to other scenarios as well.
Suppose a business that trades in widgets makes the following purchases during the year:
- Batch 1: Quantity 2,000 pieces at $4 per piece
- Batch 2: Quantity 1,500 widgets at $5 apeice
- Batch 3: Quantity 1,700 widgets at $6 per piece
This means a total of 5,200 widgets were purchased. Of these, let's assume the company managed to sell 3,000 units at a price of $7 each. Now the remaining inventory of 2,200 widgets needs to be valued. What should be the unit cost used to determine the value of this unsold inventory? This is the question that LIFO and FIFO methods attempt to answer.
Using the FIFO method of accounting, the unsold inventory is those goods that were acquired most recently. This means that all 1,700 widgets in Batch 3 and 500 of the 1,500 widgets in Batch 2 are considered unsold. So the value of the unsold inventory is (1,700 * $6) + (500 * $5) = $12,700.
The accounting profit for the company in this scenario using FIFO is calculated as follows:
- Revenue: 3,000 * $7 = $21,000
- Cost of goods sold: Batch 1 (2,000 * $4) + Batch 2 (1,000 * $5) = $13,000
- Profit: $21,000 - $13,000 = $8,000
It should be noted that this is strictly an accounting concept. It's quite possible that the widgets actually sold during the year happened to be from Batch 3. But as long as they are the same, standardized widgets, Batch 3 goods are unsold for the purposes of accounting.
Using the LIFO method for accounting will give us different results. The value of the unsold inventory will be different because the earliest acquired goods are considered unsold in LIFO. This means all 2,000 widgets from Batch 1 and 200 of the 1,500 widgets in Batch 2 are considered unsold. So the value of the unsold inventory is (2,000 * $4) + (200 * $5) = $9,000.
The accounting profit using LIFO is calculated as follows:
- Revenue: 3,000 * $7 = $21,000
- Cost of goods sold: Batch 2 (1,300 * $5) + Batch 3 (1,700 * $6) = $16,700
- Profit: $21,000 - $16,700 = $4,300
LIFO reserve is the difference between accounting cost of inventory calculated using the FIFO method and the one calculated using the LIFO method.
During inflation (period of rising prices), the FIFO inventory cost is higher than the LIFO inventory cost. Hence,
During deflation (period of falling prices), FIFO inventory cost is lower than the LIFO inventory cost. Hence,
In the example above, the LIFO Reserve is $12,700 - $9,00 = $3,700. This is also exactly equal to the difference in cost of goods sold under both methods ($16,700 vs. $13,000).
LIFO vs FIFO Pros and Cons
In general, the FIFO method provides is applicable for more business scenarios than LIFO and also provides better accounting. Advantages include:
- Goods are sold or disposed in a logical and systematic manner.
- The uniform and single file flow of goods provides efficient control of materials. This control is needed for goods that can be subjected to decay, deterioration, and quality or style change.
- The LIFO method is not supported by the IFRS. Many countries follow IFRS framework.
- More records have to be maintained and for a longer duration using the LIFO method. Most businesses carry at least some inventory at all times. With LIFO this could mean using records of goods acquired several years ago.
- When older goods are finally sold, the price could be significantly different from the cost of these goods. This could result in unexpectedly large paper gains or losses, which could have tax implications.