Fifo Or Lifo

Introduction

The choice of inventory costing method is an important one for companies since the consequence of the choice is apparent in both the balance sheet and the income statement. In periods of rising prices, companies choosing the income-reducing method of Last-in-First-out (LIFO) also leave the lower earlier prices in their inventory values.

This results in inventory values in the balance sheet that are based on the older prices and hence this understates the current assets of the company. Thus, in times of rising inventory prices, the LIFO method results in lower net incomes and also lower values in the current assets. The only advantage to choosing this method is the lower tax expenses based on the lower income. The American tax code requires the use of the LIFO method for financial reporting purposes if that method is used for tax purposes. When used for tax purposes, LIFO with its lower reported incomes correspondingly results in substantial tax savings for companies with large amounts of inventories, typically most large merchandising and manufacturing companies in the economy.

FIFO vs. LIFO

Under FIFO, the goods sold are the oldest produced or purchased by the company. LIFO is simply the opposite -- the goods sold are the most recently produced or purchased.

With both FIFO and LIFO, we are more concerned with cost allocation than the actual flow of goods. We're trying to effectively tie our costs together and may not even know about the inventory's physical flow.

LIFO, on the other hand, leads us to believe that companies want to sell their newest inventory, even if they still have old stock sitting around. LIFO's a very American answer to the problem of inventory valuation, because in times of rising prices, it can lower a firm's taxes. LIFO users will report higher cost of goods sold, and hence, less taxable income than if they used FIFO in inflationary times.

However, this perceived LIFO benefit can also create some real weirdness for companies using it. Inventory values on the balance sheet may not reflect reality under LIFO, as they're likely outdated. A company skimming off its new inventory purchases can end up with an ever-growing pile of inventory on the balance sheet, increasingly old at the core.

Differences Between FIFO and LIFO

FIFO LIFO

Periods of Rising Prices (Inflation) (+) Higher value of inventory

(-) Lower cost of goods sold (-) Lower value of inventory

(+) Higher cost of goods sold

Periods of Falling Prices (Deflation) (-) Lower value of inventory

(+) Higher cost of goods sold (-) Higher value on inventory

(+) Lower cost on goods sold

Blount, Inc.

Being an international company, Blount Inc. decided to switch into FIFO in accounting for inventories just as most of its competitors are. How did that decision affect Blount Inc.?

First, the company believes that by using FIFO instead of LIFO, it would be better able to match its costs and revenues. This is achieved because the company is using Japanese manufacturing techniques and JIT (just-in-time) methods which both lead to lower production costs, as well as, reduced inventory.

Second, the change led Blount to an increase of $3.7 million ($0.31 per share) in net income by the end of the February 1988 where the current economic environment was facing low inflation. Even though this meant higher taxes but due to what is mentioned in the first point, Blount's decision is rational.

Third, as mentioned in the previous two points, Blount's position in the market is improved by recording higher profits. In addition, this means the company would have a bigger market share than what it used to be compared to its competitors.

Therefore, Blount had three strong reasons for switching from LIFO to FIFO.

Penn Central Corporation

Unlike Blount, Inc., Penn Central Corporation, a diversified company, switched its method of valuing a major part of its electrical wire inventories from FIFO to LIFO on January 1, 1988. The company believed that such a change would make it benefit in several areas.

First is Penn Central Corporation's belief that by using LIFO, it will better match its costs with revenues.

Second, the company wanted to decrease its net income and income from operating activities and using LIFO helped by reducing both by $7.4 million or $0.10 per share. This move helped Penn Central Corporation pay less income taxes.

Third, by using LIFO for the above reasons, the company would report lower profits and this means lower dividends to shareholders.

Quaker Oats

The multinational company, Quaker Oats, decided like Penn Central Corporation to switch from FIFO to LIFO in valuing the majority of its remaining U.S. grocery products inventories. Again the reasons are as follows:

First, as mentioned for the