Q: What is FIFO vs LIFO?
A: FIFO and LIFO are two different methods used for inventory valuation. FIFO stands for First-In-First-Out, while LIFO stands for Last-In-First-Out. In other words, FIFO assumes that the oldest items in inventory are sold first and the newest items remain in stock until they are sold. On the other hand, LIFO assumes that the newest items in inventory are sold first and the oldest items remain in stock until they are sold.
Both of these methods have their own advantages and disadvantages, depending on a company’s specific circumstances. Here’s a closer look at how each method works:
FIFO Method
The FIFO method is often preferred by companies that sell products with a limited shelf life or those whose product prices tend to rise over time. This is because under this method, older (and usually cheaper) goods are assumed to be sold before newer (and more expensive) goods, resulting in higher net income figures due to lower cost of goods sold (COGS).
For example, let’s say Company A sells widgets at $10 per unit. They purchase 100 units at $5 per unit on January 1st and then another 100 units at $7 per unit on April 1st. By December 31st of that year, they have sold all but 50 units.
Under the FIFO method, Company A would assume that it had sold all of its cheaper ($5/unit) widgets first before selling any of its more expensive ($7/unit) ones. As such, COGS would be calculated as follows:
(100 x $5) + (50 x $7) = $650
LIFO Method
On the other hand, the LIFO method tends to be favored by companies who sell products with stable or declining prices over time since it allows them to match current revenues against current costs better.
Using our previous example above but with the LIFO method, COGS would be calculated as follows:
(50 x $7) + (100 x $5) = $650
As you can see, the only difference between these two methods is the order in which goods are assumed to have been sold. But this small difference can have a significant impact on net income figures and tax liabilities.
Advantages and Disadvantages of FIFO
One of the advantages of using FIFO is that it tends to provide a more accurate picture of inventory costs over time. This is especially true if your business deals with perishable or seasonal products whose prices tend to fluctuate significantly over short periods. Additionally, FIFO typically produces higher net income figures due to its lower COGS assumptions.
However, one disadvantage of using FIFO is that it may lead to higher tax liabilities since higher net income figures result in more taxable income.
Advantages and Disadvantages of LIFO
On the other hand, one advantage of using LIFO is that it tends to produce lower tax liabilities since its higher COGS assumptions lead to lower net income figures. Additionally, companies that use LIFO often benefit from cash flow advantages since they may be able to defer taxes payable by reducing their current taxable earnings through inventories’ liquidation.
However, one disadvantage of using LIFO is that it can distort inventory cost data over time if prices for goods remain stable or rise steadily over time. Also, some countries do not allow businesses operating within them under Generally Accepted Accounting Principles (GAAP), such as International Financial Reporting Standards (IFRS), standards used in Europe and much of Asia/Pacific region.
Conclusion
In conclusion, both FIFO vs LIFO methods offer unique benefits and drawbacks depending on how your business operates. It’s crucial for companies’ financial professionals always to analyze each choice carefully before choosing which accounting method best suits them while complying with relevant accounting standards required by law or regulation in their country or region.