FIFO and LIFO accounting

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This article is about FIFO and LIFO in accouning. For the terms in computing, see FIFO.

In LIFO accounting, a historical method of recording the value of inventory, a firm records the last units purchased as the first units sold. LIFO stands for "last in, first out" and is a term used in the fields of computer science and accounting. Sometimes the term FILO ("first in, last out") is used synonymously. LIFO accounting is in contrast to FIFO accounting.

Since prices generally rise over time, this method records the sale of the most expensive inventory first and thereby can reduce taxes. However, this method rarely reflects the physical flow of indistinguishable items (perhaps a heap of coal with shipments being added to and taken from the top might be an isolated case) and is not permitted under UK GAAP and IAS.

However, LIFO valuation is permitted under US GAAP in the belief that an ongoing business does not realize an economic profit solely from inflation. When prices are increasing, they must replace inventory currently being sold with higher priced goods. LIFO better matches current cost against current revenue. It also defers paying taxes on phantom income arising solely from inflation. LIFO is attractive to business in that it delays a major detrimental effect of inflation, namely higher taxes.

Because LIFO delays the recognition of profits and defers tax payments, businesses must request permission from the IRS to use the LIFO method by filing IRS Form 970, Application To Use LIFO Inventory Method.

FIFO accounting

FIFO accounting is a common method for recording the value of inventory. It is appropriate where there are many different batches of similar products. The method presumes that the next item to be shipped will be the oldest of that type in the warehouse. In practice, this usually reflects the underlying commercial substance of the transaction, since many companies rotate their inventory. This is in contrast to LIFO.

In an economy of rising prices (during inflation), it is common for beginning companies to use FIFO for reporting the value of merchandise to bolster their balance sheet. As the older and cheaper goods are sold, the newer and more expensive goods remain as assets on the company's books. Having the higher valued assets and the lower purchase costs of the sold goods part of the company's books, increases the chances of getting a loan from potential creditors for the company. However, as the company grows it may switch to LIFO to reduce the amount of taxes it pays to the government.

LIFO Liquidation

Notwithstanding its deferred tax advantage, a LIFO inventory system can lead to LIFO liquidation, a situation where in the absence of new replacement inventory or a search for increased profits, older inventory is increasingly liquidated, or sold. If prices have been rising, for example through inflation, this older inventory will have a lower cost, and its liquidation will lead to the recognition of higher net income and the payment of higher taxes, thus reversing the deferred tax advantage that initially encouraged the adoption of a LIFO system. Some companies who use LIFO have decades-old inventory recorded on their books at a very low cost. For these companies a LIFO liquidation would result in an inflated net income and higher tax payments. This situation is usually undesirable; on rare occasions a company in financial stress may abuse this method to temporarily increase income.

The LIFO Conformity Rule' is the U.S. statutory requirement that LIFO may only be adopted for tax purposes, if also used for financial reporting purposes. LIFO is the only area of the U.S. income tax law with such an explicit requirement, linking tax treatment to financial accounting practice.

FIFO and LIFO accounting

From Wikipedia, the free encyclopedia

FIFO accounting

LIFO Liquidation

See also