Hello Reader,

Do you find it hard to know when to use FIFO or LIFO?

Well you are not alone.

Recently I have met a lot of business people who need clarity and understand what are the accounting and tax implications of each method.

This why, today you are going to learn what are the differences between LIFO and FIFO and when to use them.

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Three common inventory accounting methods are FIFO (First In First Out), LIFO (Last In First Out), and WAC (Weighted Average Cost).

Each method has its advantages and impacts financial statements differently.

FIFO vs LIFO

Let's dive into the detailed comparison of inventory accounting methods.

What Are The Main Differences?

FIFO stands for First In First Out.

Under FIFO, the oldest inventory items are sold first.

LIFO stands for Last In First Out.

Under LIFO, the newest inventory items are sold first.

What Is The Impact on Financial Statements?

The choice of inventory accounting method can impact a company's profitability, tax liability, and inventory valuation.

It also affects the accuracy of financial statements, as different methods can lead to different results for the cost of goods sold and inventory valuation.

• In an inflationary environment, using FIFO will increase the value of stocks and optimize the current profit.
• Using LIFO will increase cost of goods sold and decrease income, particularly in periods of inflation. This method can be helpful to generate more short term cash flows as it optimizes the tax liability and reduces cash payout.

Where Is FIFO Used?

• Food industry: Restaurants, supermarkets, and food manufacturers use FIFO to maintain product quality and safety.
• Retail: FIFO is used to manage perishable and non-perishable products, ensuring older stock is sold first.
• Pharmaceuticals: FIFO is crucial for effective medication management and to prevent expiration.
• Warehousing & Distribution: FIFO keeps inventory moving efficiently.

Where is LIFO used?

• Manufacturing: Industries with non-perishable materials may use LIFO, as the newest items might be easiest to access.
• Tax optimization: In the US, companies use LIFO for tax advantages during periods of inflation, as it reports higher cost of goods sold and lower profits.

Another alternative: The WAC

WAC (Weighted Average Cost) averages the cost of all items in inventory, offering simplicity and moderating price fluctuation effects.

However, it may not accurately reflect the physical flow of goods, especially in industries dealing with perishable items.

Compared to FIFO, WAC smooths out cost variations but lacks the specificity of physical flow.

Compared to LIFO, WAC moderates cost figures and doesn't offer tax benefits during inflation.

Bonus/Last Tips

• There is a variant of FIFO/LIFO: the FEFO method:
  First Expiration First Out. It covers inventory management for perishable goods.
  The difference from FIFO is that you control goods by future expiration dates, instead of the warehouse entry date (used in LIFO/FIFO).
  As validity dates are getting closer, you have to move fast for delivering these perishable goods as soon as possible (Special thanks to Carlos Vinícius C. Ramos for contributing with this other type of accounting method)
• When choosing an inventory accounting method, consider the nature of your business and the type of inventory you deal with.
• You need to be consistent in your accounting methods over the years.
  Any significant change can be challenged by the tax authorities.
  If you are implementing new accounting methods, make sure to have a good argumentation and to align with the industry standards.
• Seek advice from a financial expert or consultant to understand the implications of each method on your company's financials.

What Have We Learned Today?

• FIFO stands for First In First Out, and it prioritizes selling older inventory items.
• LIFO stands for Last In First Out, and it prioritizes selling newer inventory items.
• WAC, or Weighted Average Cost, averages the cost of all items in inventory, providing simplicity but lacking specificity in physical flow.
• The choice of inventory accounting method impacts financial statements, profitability, tax liability, and inventory valuation.
• Consider the nature of your business and inventory when selecting the most suitable inventory accounting method.

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