Is LIFO or FIFO better during inflation?
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FIFO and LIFO accounting methods are used for determining the value of unsold inventory, the cost of goods sold and other transactions like stock repurchases that need to be reported at the end of the accounting period. FIFO stands for First In, First Out, which means the goods that are unsold are the ones that were most recently added to the inventory. Conversely, LIFO is Last In, First Out, which means goods most recently added to the inventory are sold first so the unsold goods are ones that were added to the inventory the earliest. LIFO accounting is not permitted by the IFRS standards so it is less popular. It does, however, allow the inventory valuation to be lower in inflationary times. Show What it meansFIFO stands for First In First Out and is an inventory costing method where goods placed first in an inventory are sold first. Recently-placed goods that are unsold remain in the inventory at the end of the year. LIFO stands for Last In First Out. It is an inventory costing method where the goods placed last in an inventory are sold first. The goods placed first in the inventory remain in the inventory at the end of the year. Example of FIFO and LIFO accounting A simplified FIFO and LIFO representation While this example is for inventory costing and calculating cost of goods sold (COGS), the concepts remain the same and can be applied to other scenarios as well. Suppose a business that trades in widgets makes the following purchases during the year:
This means a total of 5,200 widgets were purchased. Of these, let's assume the company managed to sell 3,000 units at a price of $7 each. Now the remaining inventory of 2,200 widgets needs to be valued. What should be the unit cost used to determine the value of this unsold inventory? This is the question that LIFO and FIFO methods attempt to answer. Using FIFOUsing the FIFO method of accounting, the unsold inventory is those goods that were acquired most recently. This means that all 1,700 widgets in Batch 3 and 500 of the 1,500 widgets in Batch 2 are considered unsold. So the value of the unsold inventory is (1,700 * $6) + (500 * $5) = $12,700. The accounting profit for the company in this scenario using FIFO is calculated as follows:
It should be noted that this is strictly an accounting concept. It's quite possible that the widgets actually sold during the year happened to be from Batch 3. But as long as they are the same, standardized widgets, Batch 3 goods are unsold for the purposes of accounting. Using LIFOUsing the LIFO method for accounting will give us different results. The value of the unsold inventory will be different because the earliest acquired goods are considered unsold in LIFO. This means all 2,000 widgets from Batch 1 and 200 of the 1,500 widgets in Batch 2 are considered unsold. So the value of the unsold inventory is (2,000 * $4) + (200 * $5) = $9,000. The accounting profit using LIFO is calculated as follows:
Reserve CalculationLIFO reserve is the difference between accounting cost of inventory calculated using the FIFO method and the one calculated using the LIFO method. During inflation (period of rising prices), the FIFO inventory cost is higher than the LIFO inventory cost. Hence, During deflation (period of falling prices), FIFO inventory cost is lower than the LIFO inventory cost. Hence,
LIFO vs FIFO Pros and ConsIn general, the FIFO method provides is applicable for more business scenarios than LIFO and also provides better accounting. Advantages include:
References
Which is better in inflation FIFO or LIFO?During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income.
How does inflation affect LIFO and FIFO?LIFO and FIFO: Impact of Inflation
In other words, the older inventory, which was cheaper, would be sold later. In an inflationary environment, the current COGS would be higher under LIFO because the new inventory would be more expensive. As a result, the company would record lower profits or net income for the period.
Why is LIFO good for inflation?Under LIFO, goods sold during the year are deemed to come first from goods purchased or produced during the year and then from beginning inventory. As a result, under a LIFO method, inflation on items in ending inventory is included in cost of goods sold, which could reduce taxable income significantly.
Is FIFO better for rising prices?When prices are rising, you prefer LIFO because it gives you the highest cost of goods sold and the lowest taxable income. First-in, first-out, or FIFO, applies the earliest costs first. In rising markets, FIFO yields the lowest cost of goods sold and the highest taxable income.
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