LIFO/FIFO:

The Best of Both Worlds

Chad Hasselschwert

IPFW

LIFO/FIFO:  The Best of Both Worlds

Introduction

            The purpose of this paper is to offer an explanation of the two most popularinventoryaccounting methods used today.  These methods areFIFO(first-in first-out) and LIFO (last-in first-out).  Within this explanation there will be examples for the non-business readers along with detailed definitions of the business terminology.  Both the advantages and disadvantages will be examined under both of these plans.  Refutations will be offered against each plan along with supporting arguments on the advantages of each plan.  Finally a third method will be introduced as a marriage of both the above plans, how to implement this marriage, and what effect it would have on business day-to-day and financial statements.   

FIFO

            As stated above,FIFOstands for first-in, first-outinventorytracking.  This means as a business purchases itsinventory, holds theinventory, and finally sells theinventorythe first group of purchases will be taken off the books first.  This also implies that the remaininginventoryat the end of a period will be the last group or groups of purchases acquired.  Assuming an inflationary economy, this method ofinventorytracking will provide the highest gross profit for the period.  At the same time this method also states that the remaininginventorywas purchased at the highest price level (Mangan, 2000).  Example 1 offers a hypothetical situation ofFIFO.  As demonstrated below, the first units ofinventoryreceived are the first units ofinventorytaken off the books.  Thus, leaving the higher priced units on the books.

Example 1 

                 Period Activity                                                   Result

January 15 purchased 1000 units @ $1.00/ea = $1000      EndingInventory= 1200 units

March 15 purchased 1000 units @ $1.20/ea = $1200                May 15 – 1000 @ 1.50

May 15 purchases 1000 units @ $1.50/ea = $1500                   March 15 – 200 @ 1.20

Total period purchases = 3000 units = $3700                    EndingInventoryvalue = $1740

Total period sales = 1800 units                        

           FIFOis currently the standard forinventoryaccounting.  This is because dollars on the books are added and subtracted simultaneously with the physical material that those dollars represent.  TheFIFOmethod is also chosen because it is easier for firms with fluctuating production cost to determine their cost of goods sold and to price their products.  However, sinceFIFOdoes produce a higher reported income, a firm is required to pay taxes on a higher dollar amount.  The tax benefit that LIFO can offer, by providing a lower reported income, does shed some light on why certain firms would gladly make a switch fromFIFOto LIFO (Bar-Yosef & Hughes, 1995).  With the higher reported incomeFIFOprovides the law states that a company must acquire more insurance, which mean higher premiums for that insurance (Mangan, 2000).  All of these reasons lead some managers to take a closer look into the LIFO method ofinventoryaccounting.

LIFO

            As stated above, LIFO stands for last-in, first-outinventorytracking.  This means as a business purchases itsinventory, holds theinventory, and finally sells theinventorythe last group of purchases will be taken off the books first.  This also implies that the remaininginventoryat the end of a period will be the first group or groups of purchases acquired.  Assuming an inflationary economy, this method ofinventorytracking will provide the lowest gross profit for the period.  At the same time this method also states that the remaininginventorywas purchased at the lowest price level (Mangan, 2000).  Example 2 offers a hypothetical situation of LIFO.  As demonstrated below, the last units ofinventoryreceived are the first units ofinventorytaken off the books.  Thus, leaving the lower priced units on the books.

Example 2

Period Activity                                                 Result

January 15 purchased 1000 units @ $1.00/ea = $1000      EndingInventory= 1200 units

March 15 purchased 1000 units @ $1.20/ea = $1200                Jan 15 – 1000 @ 1.00

May 15 purchases 1000 units @ $1.50/ea = $1500                   March 15 – 200 @ 1.20

Total period purchases = 3000 units = $3700                    EndingInventoryvalue = $1240

Total period sales = 1800 units                                                                        

            Historically, most firms used theFIFOmethod forinventoryaccounting.  Consequently, all of the executives’ bonuses were calculated from a base income that theFIFOmethod provided.  This level of income, in an inflationary economy, would be higher than if reported under the LIFO method.  If a manager decided to make the switch over to LIFO, his or her direct income would take a sharp nosedive, considering bonuses are based on a higher gross profit for the company.  So a simply accounting change could not be done.  The manager would also have to do one of two options:  1) completely change the bonus program to reflect the lower LIFO gross income, or 2) continue to run the books under both methods (LIFO andFIFO), LIFO for reporting accounting andFIFOto calculate bonuses.  These options both come with significant implementation and operating cost.  There are three main reasons why managers do not convert over to the LIFO method:  1) the managers foresee the LIFO method to result in lower stock trading prices, 2) the managers also foresee lower personal bonus due to the lower reported gross income, and 3) managers that retain very little or no direct ownership of the company could possibly make accounting decisions that, in the long run, benefit themselves and not the true owners, the stockholders (Abdel-Khalik, 1985). 

            As mentioned, LIFO can provide a substantial tax savings over the traditionalFIFOmethod.  This tax savings is the most important reason for a firm to convert over fromFIFOto LIFO.  However, there are significant drawbacks from the LIFO method that must be analyzed.  The first one is the particularly high bookkeeping cost associated with the LIFO method on a daily basis.  Also there are estimated costs of implementing the LIFO method that accounts for 0.7 to 7.9 percent of average profits.  Then one must consider with new technologies a firm will become efficient and lower production cost, which in turn, raises reported income that the taxes are calculated from.  Also with the LIFO method there is considerable involvedness with implementing this accounting method (Cushing & LeClere, 1992).  And finally, nominal tax advantages will be overshadowed when inflation is considered and consist dollar adjustments have been made (Kang, 1993).  Considering all of the above, there is clearly no better method than the other; bothFIFOand LIFO have advantages and disadvantages.

The marriage

            This leads to a marriage of bothFIFOand LIFO.  We can call this new crossbreed method LIFO/FIFO.  This method takes the best elements of each plan and capitalizes on them, while eliminating the drawbacks of each plan.  The paragraphs that follow will explain how to implement this plan, what laws need to be passed, and what accounting changes need to be adopted to fully benefit from this new concept (Bohan & Rubin, 1986).

            First we need to identify the advantages for both LIFO andFIFO.  LIFO adequately reports current expenses with current (and appropriate) revenues, whenFIFOdoes not match current expenses with current revenues.  However,FIFOdoes provide realisticinventoryvalues on the balance sheet, when LIFO will report oldinventoryvalues on the balance sheet.  LIFO will provide a more accurate cost of goods sold on the income statement, whenFIFOwill underestimate the cost of goods sold (Bohan & Rubin, 1986).

            So the marriage of these two methods would include usingFIFOto reportinventoryvalues on the balance sheet.  Then using LIFO to report expenses (or cost of goods sold) on the income statement.  However, some would question the validity of the values if two different methods were being using on two different financial statements.  To solve this dilemma, one would need to add a line item on the balance sheet in the owner’s equity section and include the difference of equity between the reportedFIFOinventoryvalues and the estimated LIFOinventoryvalues.  In doing this, the additional equity line item would bring the financial statements back into balance (Bohan & Rubin, 1986).

            But not so fast, current laws do not allow for such accounting to take place.  However, new laws are being passed every day and Bohan & Rubin (1986) has stated:

            Lifo/Fifoisn’t, of course, part of GAAP—only FASB action could make it so and        

            the board doesn’t have such a project on its agenda.  But Concepts Statement No.

            5, Recognition and Measurement in Financial Statements of Business Enterprises,

            does indicate that future standards may recognize some changes in net assets out-

            side of earnings (in addition to changes arising from transactions between an

            enterprise and its owners).  And footnote 33 to paragraph 51 provides as an

            example “ ‘…the ‘inventoryprofits’ that would result if cost of goods sold were

            reported on LIFO while inventories were reported onFIFO.’ ” (par. 25)

If this law could be passed it is all we would need to adopt this new hybrid LIFO/FIFOmethod.

Conclusion

            As this paper had demonstratedFIFOhas certain advantages when it comes to reportinginventoryvalue on the balance sheet; while LIFO clearly takes the advantage when cost of goods sold is calculated.  Even with the tax advantage, there are still many reasons why a firm would be hesitant to immediately switch their books over to the LIFO method.  Better still would be a marriage of both these plans, cherry picking all the advantages of both plans and trimming the fat out of the equation.  With some help from the federal government to amend certain reporting guidelines, this utopia of accounting forinventoryvalue can easily be achieved.                  

                                                   References

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Bohan, M. P., & Rubin, S. (1986).  LIFO/FIFO:  How would it work?Journal

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Cushing, B. E., & LeClere, M. J. (1992).  Evidence on the determinants ofinventory

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Mangan, J. F. (2000).  Do LIFO andFIFOmake a difference to business income

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