What is the Difference Between FIFO and LIFO in Accounting?
Without calculating profits and losses, a business cannot function. Every business maintains records of the cost of each item and the profits earned from its sales. In this regard, accounting methods like FIFO and LIFO significantly assist them.
For instance, a candy seller offers boxes of sweets. One day, a customer purchases one box of sweets, and the following week, the customer buys more boxes of the same sweets at a different price. The seller finds it challenging to determine which box was sold—the cheaper one from last week or the more expensive one from the current stock. FIFO and LIFO help them resolve this confusion.
Table Of Content
What does FIFO mean in accounting, and what are its benefits?
What is LIFO in Accounting and What are its Benefits?
Difference between FIFO and LIFO
Effect of Price Fluctuations on FIFO LIFO
How to Make the Right Choice – Accounting FIFO LIFO
How FIFO and LIFO are an International Choice?
Conclusion
Frequently Asked Questions
In FIFO, it is assumed that the first items purchased are the first ones sold. This means older (and usually cheaper) inventory is recorded as ‘sold first’. In LIFO, it’s the reverse— it is assumed that the latest items purchased are the first sold, so newer (and often more expensive) inventory is recorded as ‘sold first’.
Undoubtedly, FIFO and LIFO accounting methods assist businesses in creating financial models and comprehensive reports. But to fully understand the two concepts, one must know their differences, which this blog will explain.
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What does FIFO mean in accounting, and what are its benefits?
FIFO is the short form of ‘First-In, First-Out’. It eases accounting by managing inventory costs. FIFO means that the items bought first are the ones sold first. To be precise, FIFO automatically assumes that the unsold old products in stock are sold before the newer ones.
It mainly helps businesses that deal with products with expiry dates, like medicines and food. In such cases, the businesses ensure the items nearing their expiry dates are sold first. This way, the shops do not pile up waste products. Instead, they can sell fresh goods.
FIFO is also useful during times of rising prices. In a situation where other shops are selling expensive items, buyers can get the items at a lower price from a particular seller for whom the cost of goods sold (COGS) becomes lower. Resultantly, it amplifies profit, making a business more successful. However, this also means that taxes could be higher because of the rising profits.
Another benefit of FIFO is that it matches the natural flow of goods in many businesses. It also keeps inventory records simple and easy to understand. It is beneficial in industries where goods have a shelf life or where prices often change.
What is LIFO in Accounting and What are its Benefits?
LIFO is the short form of ‘Last-In, First-Out.’ In the accounting world, this method is used to manage inventory costs. LIFO deals with the newest items bought and assures that the ones sold first are amongst them. This means the last item that enters the inventory will leave first.
Businesses use this method to make profits during high price trends. Since the most recent (and often more expensive) goods are sold first, the cost of goods sold (COGS) is higher. As a result, the business shows a lower profit on paper. This can help reduce taxes, which is one reason some companies choose LIFO.
LIFO does not consider the nature of the goods sold, especially for those that get spoiled easily, like food. So, it is not used in industries dealing with such goods. The most common businesses that consider LIFO are those that deal with durable products like steel, cement, etc.
However, LIFO can make the inventory records complicated and hard to understand. Since older items stay in stock longer, the value of inventory on paper may be low and not match current market prices. Still, LIFO is a useful accounting method during inflation.
Difference between FIFO and LIFO
The main difference between FIFO and LIFO is how they handle the cost of inventory. They each make different guesses about which items are sold first. This leads to big changes in how much the company says it spent on goods, how much inventory is left, how much profit it made, and how much tax it has to pay. Here’s a simple look at how and why FIFO and LIFO are not the same.
| Variation Probabilities | FIFO | LIFO |
|---|---|---|
| Cost of goods sold (COGS) | COGS reflects the cost of the oldest inventory. In periods of rising prices, FIFO generally results in a lower COGS. | COGS reflects the cost of the newest inventory. In periods of rising prices, LIFO generally results in a higher COGS. |
| Ending inventory | Ending inventory reflects the cost of the newest inventory. In periods of rising prices, FIFO generally results in a higher ending inventory value. | Ending inventory reflects the cost of the oldest inventory. In periods of rising prices, LIFO generally results in a lower ending inventory value. |
| Net income | In periods of rising prices, the lower COGS under FIFO leads to a higher gross profit and, consequently, a higher net income. | In periods of rising prices, the higher COGS under LIFO leads to a lower gross profit and, consequently, a lower net income. |
| Tax implications | Higher net income in periods of rising prices can result in higher income taxes. | Lower net income in periods of rising prices can result in lower income taxes (this is a primary reason why some US companies prefer LIFO when permissible). |
| Realism of cost flow | More closely aligns with the actual physical flow of most inventory. | Does not typically reflect the physical flow of goods. |
| Acceptability under accounting standards | Widely accepted under both GAAP and IFRS. | Permitted under GAAP in the United States but prohibited under IFRS. |
| Balance sheet versus income statement | Tends to provide a more realistic valuation of ending inventory on the balance sheet because it’s based on more recent costs. | Tends to provide a more realistic matching of current costs with current revenues on the income statement (in periods of rising prices). |
Effect of Price Fluctuations on FIFO LIFO
It is crucial to make the right choice in accounting. One should know when to use FIFO and when to use LIFO. It largely affects a company’s records, especially when prices go up or down. Such fluctuations keep happening. So, a blunder can happen if the right accounting method is not chosen. Businesses can face critical situations. Let us find out how FIFO and LIFO react during two common situations: when prices are rising and when prices are falling.
When prices are rising
FIFO Effects
- Uses older, cheaper items first
- This leads to a lower cost of goods sold (COGS)
- Profits appear higher
- Ending inventory looks more accurate (closer to current prices)
- The company may pay higher taxes due to higher profits
LIFO Effects
- Uses newer, more expensive items first
- This leads to higher COGS
- Profits appear lower
- Ending inventory may seem understated (based on older, cheaper prices). The company pays lower taxes
When prices are falling
FIFO Effects
- Uses older, more expensive items first
- This leads to higher COGS
- Profits appear lower
- Ending inventory value is higher
- The company may pay lower taxes
LIFO Effects
- Uses newer, cheaper items first
- This leads to lower COGS
- Profits appear higher
- The ending inventory value is lower
- The company may pay higher taxes
FIFO gives a more realistic ending inventory value because it reflects recent prices. However, in times of rising prices, FIFO shows higher profits, which can lead to higher taxes.
LIFO, on the other hand, lowers profits during inflation by using recent higher costs first. This helps reduce taxes, but may not show the real value of what is left in stock.
Both FIFO LIFO have their pros and cons. So, whichever method a company chooses will significantly impact how its financial health looks on paper. FIFO and LIFO do not change the actual inventory, but they do change how it is reported. That’s why choosing the correct method is important, especially when prices go up and down often.
How to Make the Right Choice – Accounting FIFO LIFO
Both FIFO and LIFO are essential for businesses, but they must not make a blind choice based on accounting rules. Each accounting method affects businesses predominantly, but not in the same way. FIFO’s effects are different from those of LIFO. So, before selecting any one of them, the businesses must consider their type of operations, the products they sell, and how the price of their products fluctuates with time. The factors that they must not forget are –
- Industry Type: FIFO is better for businesses that sell products with a shelf life, like food or medicine. LIFO may suit businesses with items that don’t expire, like hardware or building supplies.
- Price Changes: If prices rise, LIFO helps reduce taxes by showing lower profits. FIFO shows higher profits, which may lead to higher taxes, but looks better to investors.
- Inventory Flow: FIFO matches the natural order of goods sales—the oldest items go first. This makes it easier to manage stock and avoid waste.
- Financial Reporting: FIFO shows a more realistic value of leftover inventory. LIFO may show older, lower costs, making inventory values look outdated.
- Legal Rules: Some countries don’t allow LIFO for tax or reporting purposes. Companies must follow local laws when choosing a method.
- Ease of Use: FIFO is simpler and more common in many businesses. LIFO can be more complex to track and may require extra work.
Whatever the factor, the choice between FIFO LIFO finally depends on the target of the business concerned. To get more insights on this matter, students can check out some important online finance courses.
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How FIFO and LIFO are an International Choice?
Different countries have different rules for using FIFO and LIFO. FIFO is accepted in most places around the world because it gives a clear picture of inventory and profit. It follows the natural flow of goods and is allowed under international accounting standards (IFRS). LIFO, however, is not accepted in many countries outside the United States. It can be helpful for tax savings, but it does not always show the real value of inventory. So, while FIFO is more globally accepted, LIFO is primarily a local choice for companies in specific regions like the U.S.
Conclusion
It may appear small, but choosing between FIFO and LIFO is a crucial task. These two accounting methods may sound similar, but they affect businesses differently. The outcome may be beneficial or unprofitable, depending on how and when FIFO and LIFO are applied. The businessmen’s choice of these accounting methods will decide whether their businesses thrive or go down. FIFO and LIFO have the power to change a company’s financial reports within a short time. Thus, every business needs to consider its industry, product type, and ongoing market conditions before picking a method. Both FIFO and LIFO have positive and negative effects. Hence, businessmen and accounting professionals must understand both these methods properly before deciding. Picking the right one at the right time will help the company to thrive.
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Frequently Asked Questions
