In order to properly report their total cost of goods sold (cogs) on their financial statements and income taxes, companies must resort to one of the three calculations known as the company’s inventory valuation methods set in place by GAAP. These include the so-called FIFO, LIFO, and the weighted average inventory cost flow assumptions (IFRS)which are the most popular inventory methods when it comes to the United States tax law. The FIFO method, which stands for the First-In-First-Out, will remove the oldest inventory items from the inventory first. Contradictory, Last-In-First-Out method (LIFO inventories) will first get rid of the items that were produced recently. Lastly, the weighted average method simply takes the average of all units and expenses them at the same cost.
Why The Different Methods?
Although there are many implications as to why companies resort to using one of the aforementioned inventory costs methods, the SEC originally intended to provide businesses with alternatives depending on their inventory’s spoilage and customization. For instance, companies that produce liquid products like chemicals or fuel may be unable to distinguish between the first and the last gallon. Thus, they get to use the weighted average cost.
LIFO and FIFO, on the other hand, are more closely related to income statement transactions and manipulations that will result in less taxable income. For instance, if one is experiencing a period of rising costs, they will seldom use the FIFO method of inventory valuation. Instead, they will charge the latest costs of production to their revenues in order to reduce the taxable income. Thus, the use of LIFO methods will be more likely to come into play when periods of inflation are taking place or when there are periods of rising prices in raw material costs.
FIFO, on the other hand, will give one a more accurate depiction of their ending merchandise inventory balance or asset. The FIFO method also falls under International Financial Reporting Standards as well as GAAP. Consider, for example, a tech-based company that sells laptops. If they purchase and have 200 laptops from 2016 as their beginning inventory that is worth $200 each and another 200 from 2018 that are worth $300 each, they will first write off the costs of the older ones. So, the amount left in their year-end (read unsold) or ending inventory will be based on the cost of those laptops from 2018. Hence how it is a more recent depiction of their inventory valuation on the balance sheet.
As with nearly everything in accounting, both LIFO and FIFO come with a few disadvantages when representing a company’s financial information. LIFO’s main disadvantage will be the fact that it can result in lower operating profits. Although this is beneficial for tax purposes, it is not great for a company to report fewer earnings or a lower net income. In fact, doing so can be very repulsive to potential investors.
FIFO, on the other hand, has an issue when it comes to consistency. If one is constantly charging their oldest costs against their recent revenues, they will frequently see discrepancies in the profits. For instance, if those computers from 2016 are sold for $500, the company has a $300 profit. If the ones from 2018 go for the same price, however, the profit is now only $200. So, having to constantly change one’s asking prices to account for the rising costs under FIFO may be an issue for someone’s customers.
Using FIFO And Changing Methods
One of the most popular examples for companies that use FIFO are businesses with perishable goods. Think about a company that sells milk. In order to avoid spoilage, they must get rid of the oldest batches first. Thus, the FIFO inventory account method makes much more sense in their case.
If a business decides to change its cost flow assumption, the SEC will generally permit this if certain rules are followed. First, the change will have to be retrospective. Meaning, it will result in a restatement of some of the annual reports and balance sheet for the previous few years. Additionally, the IRS must be properly notified and certain forms must be completed. Nevertheless, most companies avoid going through this procedure as the benefits are heavily outweighed by the costs.