FIFO vs. LIFO

While inventory may seem like a straight forward balance sheet account there are different ways of valuing inventory that can have a significant impact on a company's income. First in first out (FIFO) and last in first out (LIFO) are two of the more prominent ways of valuing inventory and a company using one versus the other can have significantly different results. This article will help you with understanding the two and their implications when considering companies using FIFO vs. LIFO.

FIFO

FIFO refers to inventory valuation where the first unit included in inventory, or the oldest unit, will be the first one removed and expensed to cost of goods sold when comparable inventory is sold.
For example, if a company makes 10,000 cars and sells 9,500 of them, the cost of producing the first 9,500 will be removed from inventory and expensed to the income statement. The 500 remaining cars in inventory will be the last 500 units produced. Typically as costs go up over time (i.e. raw materials and labor) this means that the 500 cars still in inventory will likely have a higher value than many of the cars that were expensed to the income statement.

FIFO can be used for accounting and tax purposes and results in inventory being valued relatively higher, with lower costs being expensed to the income statement. This is thought to be a more accurate representation of the true inventory value, as in reality those last 500 cars from the example above have a higher cost than the first 500 cars that would have been produced.

LIFO

LIFO is the opposite of FIFO in that when a unit is sold you would remove from inventory, and expense to the income statement, the last unit that you actually produced and put in inventory. Using the same car example above, after selling 9,500 cars you would have in inventory still the first 500 units that you produced. This can compound over years to the point where the value of inventory still reflects the first 500 units produced even if you produced them 5-10 years ago. This results in a lower inventory value over time and higher expenses.

LIFO can be used for accounting and tax purposes in the U.S. and some other countries but is not allowed under International Financial Reporting Standards (IFRS) used in most countries in the world. This is because it is thought to not fairly reflect the actual fair value of the inventory assets a company holds.

There is some truth in this for companies that have been using LIFO for an extended period of time. ExxonMobil for example has used LIFO for many years and as a result their inventory balance is $21.2 billion lower than it would be were they to use FIFO for inventory valuation.

FIFO vs. LIFO

For companies in the U.S. who have the option to use FIFO or LIFO the decision can vary from industry to industry. Many would ask why anyone would choose LIFO as it drives higher expenses and results in lower income. The reason comes down largely to tax, where companies can expense more and reduce their overall tax bill over time. When you consider the ExxonMobil example the company has expensed $21.2 billion more over the years than they could under FIFO, drastically reducing their tax bill over the years. Investors understand this and so the company's earnings per share and net income being lower than they could be is not looked at critically. The company ends up with more cash at the end of the day, which can be reinvested or distributed to those same investors.
By Jeffrey Glen

Copyrighted 2016. Content published with author's permission.

Posted in ...