A company’s profitability will be impacted by the methodology used to calculate its inventory expenses. FIFO vs LIFO taxes will directly depend on how much profit it reports.
Inventory describes created commodities or things that have been purchased with the intent to be sold (including labor, material & manufacturing overhead costs).
FIFO and LIFO are merely hypotheses. Rather than tracking physical inventory, the approaches only track inventory totals. This does imply that a business employing the FIFO technique might be selling off more current goods first, or vice versa with the LIFO system.
However, both approaches must be predicated on inventories being sold in accordance with their intended orders for the cost of goods sold (COGS) computation to be valid.
First in, first out businesses value their inventory with the presumption that the first products they create or buy should also be the first products they sell. (This might not always be the case, as some businesses stock both new and used goods.)
Businesses utilizing FIFO are thought to be more profitable – at least on paper – due to economic swings and the risk that the cost of producing items may increase over time. The FIFO inventory valuation method is frequently used by businesses that sell perishable goods or units vulnerable to obsolescence, such as food products or designer clothing.
For instance, a supermarket business constantly buys milk to stock its shelves. Stockers move the oldest merchandise to the front as customers purchase milk and place fresher milk behind those containers. First sold are milk cartons with the earliest expiration dates, followed by milk cartons with later expiration dates. This procedure makes sure that outdated products are sold before they expire or become unusable, preventing lost revenue.
The choice of an organization’s accounting technique can have a big impact on valuations, according to Anil Melwani, a CPA and partner at the New York accounting firm Tinton Grub man CPAs LLP.
“FIFO boosts net income because inventory that may be several years old is used to assess the cost of goods sold,” Melwani said. “FIFO offers us a better idea of the value of ending inventory on the balance sheet.” Increasing net income sounds nice, but keep in mind that it may also result in a corporation paying more in taxes.
Until the additional tax liability is taken into account, FIFO is the perfect valuation method for companies that need to impress investors. FIFO reports a greater level of pretax earnings since it leads to a lower recorded cost per unit. Additionally, as profits rise, taxes for businesses will also rise.
How to Calculate FIFO
According to Stephanie Ng, a CPA and the creator of the website I Pass the CPA Exam, you should start by figuring out the cost of your oldest inventory in order to determine the cost of goods sold (COGS) under FIFO. To calculate the costs related to the sale of goods using FIFO, multiply this cost by the quantity of inventory sold.
For the purposes of this calculation and the ones that follow, we’ll focus on periodic FIFO. Here is Ng’s sample formula:
Beginning inventory + Purchases = Goods available for sale – Ending inventory = Cost of goods sold ($X, XXX)
You can rewrite this equation in a different way to find the ending inventory, according to Ng. “In other words, the products that are available for sale less the expenses of goods sold make up ending inventory utilizing the FIFO approach. This can be used to support the ending inventory amount in cases where a physical inventory count has not been performed.
Example of FIFO
It’s critical to understand how FIFO functions once you have a firm grasp of what it is and what it represents for your company. Ng provided a real-world FIFO scenario to demonstrate how the formula works.
She explained, “Let’s say Candle Corporation is in its first year in business and they bought two batches of goods throughout the year. “Batch 1 consisted of 3,000 units at $1.25 each. Batch 2 had 6,000 units for a price of $1.75 each. A total of 7,000 units were sold. Following the first purchase, 2,000 units were sold, and 5,000 units were sold following the second. Start by calculating the commodities available for sale before calculating ending inventory and expenses of goods sold using FIFO in a periodic inventory system.
Using this example and the above formula, this is how Candle Corporation would calculate its goods available for sale:
Beginning inventory ($0) + Batch 1 purchases (3,000 units @ $1.25 each: $3,750) + Batch 2 purchases (6,000 units @ $1.75 each: $10,500) = Goods available for sale ($14,250)
Ng noted that although ending inventory isn’t provided in this circumstance, you can “squeeze” out this value using the cost of products sold. You must first account for selling your oldest inventory under FIFO. Since Batch 1 in this instance is the oldest, we want to utilize up all of that inventory first. The remaining items will then come from Batch 2. Remember that a total of 7,000 units were sold.
Here’s how Ng calculated the total cost of goods sold using periodic FIFO:
COGS from Batch 1 (3,000 units @ $1.25 each: $3,750) + COGS from Batch 2 (4,000 units @ $1.75 each: $7,000) = Total COGS ($10,750)
Now, you can calculate the ending inventory:
Goods available for sale ($14,250) – COGS ($10,750) = Ending inventory ($3,500)
It is irrelevant when computing the cost of goods sold or closing out inventory using periodic FIFO, according to Ng. Simply put, it’s crucial to exhaust the oldest stock first.
What is LIFO and How Does Tt Work?
The cost of goods sold is calculated using current pricing rather than the price you paid for the inventory that is currently on hand under the latest in, first out inventory technique. The cost of items sold will be higher if the price of the goods has increased after the first purchase, which will lower earnings and tax obligations. Nonperishable goods (such as metals, chemicals, and petroleum) are typically subject to LIFO accounting when it is permitted.
According to Melwani, “LIFO isn’t a strong indicator of ending inventory value because the leftover goods may be quite old and maybe obsolete.” “This causes a valuation that is substantially lower than current prices. Because of the greater cost of products sold as a result of LIFO, there is a reduced taxable revenue.
One of the main reasons some businesses like LIFO is the decreased tax liability. Your cost base is higher on current income statements because more recent inventory was used when valuing the inventory, according to Melwani. “This has a negative impact on net income and gross profit. This is what LIFO implies, and many businesses want it because it results in less taxation and less profit reporting.
How to calculate LIFO
Ng provided a LIFO calculation formula. For this formula and the ones that follow, periodic LIFO will once more be the main focus. Ng asserts that a large portion of the procedure, including this fundamental formula, is similar to FIFO. She pointed out that the variances arise when deciding which products to claim you sold.
Beginning inventory + Purchases = Goods available for sale – Ending inventory = Cost of goods sold
Example of LIFO
Consider a website development company that spends $30 on a plugin and charges $50 for the finished product. The plugin’s cost then rises to $35 after a few months. The most recent price of $35 would be used to assess the company’s profits. According to tax records, the business only seems to have produced a profit of $15.
A business would appear to be producing less money than it actually did by utilizing LIFO, which would require it to report paying less tax.
Ng cited the Candle Corporation and its batch-purchase quantities and costs as an additional illustration. We’ll start by figuring out the overall cost of products sold.
You must take into account selling your newest inventory first under LIFO. You want to utilize up that inventory first because Batch 2 was bought more recently, according to Ng. “Batch 2 only saw a purchase of 6,000 units, however 7,000 units were sold. In other words, use the 6,000 first, then the remaining 1,000 units from Batch 1 that were sold.
Ng kept the purchase prices constant and made no effort to establish whether the current price was greater or lower in order to keep things simple. The numbers in action are as follows:
COGS from Batch 2 (6,000 units @ $1.75 each: $10,500) + COGS from Batch 1 (1,000 units @ $1.25 each: $1,250) = Total COGS ($11,750)
Now, we’ll need to calculate the ending inventory:
Goods available for sale ($14,250) – COGS ($11,750) = Ending inventory ($2,500)
The LIFO tenet heavily depends on how market-based fluctuations in the cost of commodities affect prices. Long-term inventory holdings can be very beneficial for hedging earnings against taxes. Due to the greater cost of products, LIFO enables bigger after-tax earnings. In addition, these businesses run the danger of all previously purchased inventory being negatively impacted by a decrease in the cost of goods in the case of a recession.
Restrictions on the Use of LIFO
International Financial Reporting Standards (IFRS), a set of uniform guidelines for accountants who operate globally, forbid LIFO. Although many countries already use IFRS, the United States still follows generally accepted accounting rules (GAAP). By outlawing LIFO, the United States would remove a barrier to implementing IFRS and simplify accounting for multinational firms.
However, U.S.-based businesses that utilize LIFO are required to change their statements to FIFO in their financial statement footnotes due to the existing disparity. The “LIFO reserve” refers to this variation. It is calculated using both the LIFO and FIFO cost of goods sold. This makes LIFO and FIFO enterprises more comparable.
International and American standards are generally moving away from LIFO. The majority of American-based businesses now use FIFO. Some businesses still manage their inventories using LIFO in the US, but
when it comes to tax filing, they switch to FIFO. Only a select few sizable businesses in the US are still able to declare taxes using LIFO.
While many other organizations use FIFO with little negative financial impact, some corporations feel that eliminating LIFO will result in tax increases for both large and small enterprises.
While management is free to select the best cost flow assumption, FIFO best captures the actual movement of inventory, according to Ng. Before deciding between LIFO and FIFO, management should take the business strategy, tax ramifications, and foreign financial needs (if any) into account.
FIFO and LIFO Similarities and Differences
The inventory management strategies FIFO and LIFO are extremely dissimilar. They are alike in one respect, though: Both rely on the product being the same, with the company’s cost basis (the cost of production or purchase price) being the sole variable factor.
On paper, a company’s earnings are impacted by FIFO and LIFO. The main variations are as follows:
FIFO: works best in sectors where prices are stable and businesses priorities selling their oldest products first. This is so because FIFO ignores price increases or decreases for newer units and bases its calculations on the cost of the first item purchased.
LIFO: It is effective. Because FIFO increases net income at times of rising prices, it also increases income tax expenses, according to Ng. On the other hand, using the LIFO approach at a time of increasing prices will lead to decreased net income. Therefore, using this approach would result in decreased income tax costs.
Another difference is that FIFO can be utilized for both U.S.- and internationally based financial statements, whereas LIFO cannot.
Implementing FIFO or LIFO in Your Business
Businesses’ taxes may be impacted by how they value their inventory. It also has an impact on the financial reports that businesses submit to banks when they request loans. In general, businesses are permitted to use one technique for their financial statements and another for their taxes. Although this might become hard, picking the greatest alternative for your company might help you realize a variety of commercial objectives.
Cost of Goods Sold
Unless it is sold, inventory is not immediately taxed. However, because it is regarded as a portion of your company’s net profit, its value is taxable. At other words, although the inventory in your warehouse is not taxed while it is there, the cost of purchasing and selling it is included in determining the cost of goods sold and is disclosed as a component of the taxable profit of your business.
The following formula is used to determine the cost of goods sold:
- Starting inventory plus additions and acquisitions minus ending inventory plus nondeductible items for personal use equals cost of goods sold.
- This means that both the amount of products you buy and sell during your tax year and your ending inventory need to be carefully tracked by your organization.
The majority of businesses value their inventory using either the first-in-first-out (FIFO) or last-in-first-out (LIFO) methods of accounting, while there are additional approaches to determine the cost of goods sold. The term “FIFO” stands for first in, first out. It is the exact reverse of the LIFO (last-in-first-out) principle, according to which the most recent purchases are made first. Although FIFO is the most popular strategy in the US, it may not be the best option for your company.
If, for instance, you anticipate that the price of your goods will rise over time, using LIFO may result in cheaper taxes, but the way that inventory is represented on your financial statements may make it more difficult for you to obtain a bank loan.
Pros and Cons of the Methods
Each method has benefits and drawbacks. Consider the following while choosing a method:
- The oldest products in your warehouse are the cheapest when prices are rising, whereas the most recent products are the priciest. Your profits and income taxes will both increase if you use FIFO. The opposite is true if costs are going down. The cost of goods sold will rise if you employ FIFO since the oldest products in your inventory will cost the most money. You’ll pay less in taxes.
- Supplies move. Businesses typically utilize their current inventory before ordering more.
- The International Financial Reporting Standards (IFRS) prohibit the use of LIFO for companies with global operations. IFRS regulations are based on principles as opposed to precise instructions. There are restrictions, but the IRS permits LIFO reporting.
- Cost variations. Inventory is continuously depleted when using FIFO. Because there is always older inventory on hand, that is not always the case with LIFO. Price variations are not a problem when using an alternative pricing method, such as the average cost approach, where your average cost for the period is allocated to all things.