During business activities at the end of the financial year, various accounting techniques are used to compute the value of closing inventory, cost of goods sold, and stock repurchases, like LIFO and FIFO.
LIFO stands for Last In First Out, whereas FIFO stands for First In First Out.
- LIFO is a method of inventory valuation that assumes that the last items purchased are the first ones sold, while FIFO assumes that the first items purchased are the first ones sold.
- LIFO is more commonly used in industries where inventory costs tend to rise over time, such as in the case of inflation, while FIFO is more suitable for industries where inventory costs are relatively stable.
- While LIFO can result in lower taxable income in rising costs, it can also lead to inventory obsolescence and reduced profits. In contrast, FIFO results in higher taxable income in periods of rising costs but can help to maintain more accurate inventory values and reduce the risk of obsolescence.
LIFO vs FIFO
The difference between LIFO and FIFO is that the most recently added goods are sold first and fall under the category of Last In First Out or LIFO. The most recently added products to the stock that remains unsold fall under the category of First In, First Out, or FIFO.
Last In, First Out (LIFO) is a technique that is used to account for the stock. LIFO is a method that is very famous in the United States, and it is operated by the Generally Accepted Accounting Principles (GAAP).
Under this method, the price of the most recently purchased goods is to be taken into consideration first.
First In, First Out (FIFO) is an accounting technique where the assets or goods acquired first are disposed of firsthand.
This method is based on the assumption that the remaining stock consists of items obtained last. FIFO maintains a limited number of accounts under it.
|Parameters of Comparison||LIFO||FIFO|
|Meaning||LIFO is a stock valuation method where the last purchased inventory is issued first-hand.||FIFO is a stock valuation mechanism in which the first bought inventory of goods is issued first.|
|Recommendation||IFRS does not suggest the usage of LIFO for the valuation of stock in Accounting.||IFRS recommends the use of FIFO for the valuation of stock in Accounting.|
|Present Inventory||It represents the oldest stock of goods.||It represents the latest stock of goods.|
|Present Market price||The current market price is indicated by the cost of goods sold.||The current market price is indicated by the cost of unsold goods.|
|Impact of Inflation||Here the income tax displays the minimum possible amount when there is inflation in the economy.||In an inflationary state, income tax shows a high amount.|
|Deflation||In the state of deflation, a substantial amount of income tax is shown.||In a deflationary situation, reduced income tax is shown.|
What is LIFO?
In order to account for the value of the inventory, there are several methods to do it. One of the most prominent ones is LIFO, in which the first products placed in the inventory are first sold in the accounting year.
This technique is used in the process of calculating the Cost of Goods Sold (COGS).
One of the major drawbacks of this method is the decrease in the profits for a business, but it also helps in providing the benefit of less corporate tax.
In case of a cost increase by the company, these savings significantly prove to be a boon for the company in the future.
LIFO is only legal and permitted in the United States under the provision of Generally Accepted Accounting Principles (GAAP). All the companies in the US follow the law as per GAAP.
In countries other than the US, like India, Russia, and Canada, LIFO is not permitted, and they follow the International Financial Reporting Standards (IFRS).
LIFO is very profitable for American companies as it helps them to reduce the tax burden; hence is widely used in the United States.
Under this system, bookkeeping is very difficult and complex as well. It may also fail to indicate the true cost of the company.
What is FIFO?
FIFO, also known as First in, First out, assumes the oldest goods in the stock have been sold first. FIFO has been accepted all around the world and comes under the International Financial Reporting Standards (IFRS).
The method of calculating the Cost of goods sold under FIFO is to just determine the cost of the oldest inventory and multiply it by the amount of inventory sold.
The various advantages of FIFO are:-
- This method is widely accepted and is very easy and simple to understand.
- The financial statements formed are very hard to manipulate.
- It helps a company earn higher profits.
- It also results in minimum waste of the inventory.
The main disadvantage of FIFO is that in the process of getting more profits for the business, it may result in increasing the amount of tax, and sometimes a company using the FIFO method tends to overestimate the profits, which may result in poor planning and execution of operations.
Nowadays, investors and companies prefer FIFO over LIFO since it is one of the most transparent techniques for calculating the cost of goods sold. It helps businesses declare more profits, and they make the company more attractive to potential investors.
Main Differences Between LIFO and FIFO
- IFRS restricts companies from making use of LIFO, whereas IFRS allows companies to make use of FIFO during the preparation of financial statements.
- LIFO is given lower preference in the balance sheet, whereas FIFO is given more preference in the balance sheet.
- The number of records maintaining in LIFO decreases, whereas the number of records maintaining in FIFO increases eventually.
- LIFO is widely used all around the US, whereas FIFO is used in all countries other than the United States.
- During deflation, the number of profits reduces in LIFO, whereas the number of profits increases in FIFO.
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.