FIFO vs. LIFO Accounting - Inventory Management System
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 is an acronym for "last in, first out." 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. Canadian GAAP permits its use for reporting purposes, while the Canada Revenue Agency does not allow LIFO to be used for tax filing. 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 often delays the recognition of profits and defers tax payments, businesses may request permission from the IRS to use the LIFO method by filing IRS Form 970, Application To Use LIFO Inventory Method.
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.
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 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. When a dealer sells goods from inventory, the value of the inventory reduces by the cost of goods sold. For commodity items that one cannot track individually, accountants must choose a method to identify the nature of the sale. Two popular methods exist: FIFO and LIFO accounting (first in - first out, last in - first out). FIFO regards the first unit that arrived in inventory the first one sold. LIFO considers the last unit arriving in inventory as the first one sold. Which method an accountant selects can have a significant effect on net income and book value and, in turn, on taxation. Using LIFO accounting for inventory, a company generally reports lower net income and lower book value due to the effects of inflation. This generally results in lower taxation. Due to LIFO's potential to skew inventory value, UK GAAP and IAS have effectively banned LIFO inventory accounting.
Standard Cost Accounting
Standard cost accounting uses ratios called efficiencies that compare the labor and materials actually used to produce a good with those that the same goods would have required under "standard" conditions. As long as similar actual and standard conditions obtain, few problems arise. Unfortunately, standard cost accounting methods developed about 100 years ago, when labor comprised the most important cost in manufactured goods. Standard methods continue to emphasize labor efficiency even though that resource now constitutes a (very) small part of cost in most cases.
Standard cost accounting can hurt managers, workers, and firms in several ways. For example, a policy decision to increase inventory can harm a manufacturing managers' performance evaluation. Increasing inventory requires increased production, which means that processes must operate at higher rates. When (not if) something goes wrong, the process takes longer and uses more than the standard labor time. The manager appears responsible for the excess, even though s/he has no control over the production requirement or the problem.
In adverse economic times, firms use the same efficiencies to downsize, rightsize, or otherwise reduce their labor force. Workers laid off under those circumstances have even less control over excess inventory and cost efficiencies than their managers.
Many financial and cost accountants have agreed for many years on the desirability of replacing standard cost accounting. They have not, however, found a successor.
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FIFO vs. LIFO Accounting - Inventory Management System