Why would a company use LIFO instead of FIFO? If a company that sells products (retailer, manufacturer, etc.) finds the cost of its items increasing, the use of LIFO will result in less taxable income and less income tax payments than FIFO. Over a long period of time, or when costs increase dramatically, the lower income tax payments will be significant. The Last-in First-out (LIFO) method of inventory valuation is based on the assumption that assets produced or acquired last are the first to be expensed. In other words, under the FIFO method, the latest purchased or produced goods are removed and expensed first.

What is First-In First-Out (FIFO)? The First-in First-out (FIFO) method of Inventory Inventory is a current asset account found on the balance sheet consisting of all raw materials, work-in-progress, and finished goods that a company has accumulated. It is often deemed the most illiquid of all current assets, and thus it is excluded from the numerator in the quick ratio calculation. Valuation is based on the assumption that the sale or usage of goods follows the same order in which they are bought.

In other words, under the first-in, first-out method, the earliest purchased or produced goods are removed and expensed first. Therefore, the most recent costs remain on the balance sheet while the oldest costs are expensed first. FIFO is also called last-in-still-here (LISH).

Example of First-In, First-Out (FIFO) Company A reported beginning inventories of 100 units at $2/unit. In addition, the company made purchases of: • 100 units @ $3/unit • 100 units @ $4/unit • 100 units @ $5/unit If the company sold 250 units, the order of cost expenses would be as follows: As illustrated above, the Cost of Goods Sold (COGS) Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct labor cost, and direct factory overheads, and is directly proportional to revenue. As revenue increases, more resources are required to produce the goods or service. COGS is often is determined with beginning inventories and moves its way downwards (to more recent purchases) until the required number of units sold is fulfilled. For the sale of 250 units: • 100 units at $2/unit = $200 in COGS • 100 units at $3/unit = $300 in COGS • 50 units at $4/unit = $200 in COGS The total cost of goods sold for the sale of 250 units would be $700. The remaining unsold 150 would remain on the balance sheet as inventory at a cost of $700.

• 50 units at $4/unit = $200 in inventory • 100 units at $5/unit = $500 in inventory FIFO vs. LIFO To reiterate, FIFO expenses the first.

In the following example, we will compare FIFO to Last-In First-Out (LIFO) The Last-in First-out (LIFO) method of inventory valuation is based on the assumption that assets produced or acquired last are the first to be expensed. In other words, under the FIFO method, the latest purchased or produced goods are removed and expensed first. Therefore, the old inventory costs remain on the. LIFO expenses the most recent costs first. Consider the same example above.

Recall that under First-In First-Out we had the following cost flows for the sale of 250 units: Compare this to the LIFO method of inventory valuation, which expenses the most recent inventories first: Under LIFO, the sale of 250 units: • 100 units at $5/unit = $500 in COGS • 100 units at $4/unit = $400 in COGS • 50 units at $3/unit = $150 in COGS The company would report a cost of goods sold of $1,050 and inventory of $350. Under FIFO: • COGS = $700 • Inventory = $700 Under LIFO: • COGS = $1,050 • Inventory = $350 Therefore, we can see that the financial statements for COGS and inventory depend on the inventory valuation method used. In Canada, Canadian companies are not permitted to use LIFO. However, US companies are able to use both FIFO and LIFO.

As we will discuss below, the FIFO method creates several implications on a company’s financial statements. Impact of FIFO Inventory Valuation Method on Financial Statements Recall the comparison example of First-In First-Out and another inventory valuation method – LIFO. The two methods yield different inventory and COGS. Now it is important to consider – what impact does using FIFO make on a company’s financial statements? High quality of balance sheet valuation By using FIFO, the balance sheet shows higher quality information about inventory.

It does not affect the most recent purchases thus providing high-quality information about the valuation of inventory. For example, consider a company with a beginning inventory of two snowmobiles at a unit cost of $50,000. The company purchases another snowmobile for a price of $75,000. For the sale of one snowmobile, the company will expense the cost of the older snowmobile – $50,000. Therefore, it will provide higher-quality information on the balance sheet compared to other inventory valuation methods as the cost of the newer snowmobile shows a greater resemblance to the current value. Low quality of income statement matching Since First-In First-Out expenses the oldest costs (from the beginning of inventory), there is poor matching on the income statement.