FIFO vs LIFO Inventory Valuation

This scenario occurs in the 2010 financial statements of ExxonMobil (XOM), which reported $13 billion in inventory based on a LIFO assumption. In the notes to its statements, Exxon disclosed the actual cost to replace its inventory exceeded its LIFO value by $21.3 billion. As you can imagine, under-reporting an asset’s value by $21.3 billion can raise serious questions about LIFO’s validity. But the cost of the widgets is ifrs lifo based on the inventory method selected. Last in, first out (LIFO) is a method used to account for business inventory that records the most recently produced items in a series as the ones that are sold first. That is, the cost of the most recent products purchased or produced is the first to be expensed as cost of goods sold (COGS), while the cost of older products, which is often lower, will be reported as inventory.

1. FIFO can be a better indicator of the value for ending inventory because the older items have been used up while the most recently acquired items reflect current market prices.
2. Accordingly, these decommissioning and restoration costs are recognized in profit or loss when items of inventory have been sold.
3. The difference between these two approaches is on the methodology to assess an accounting treatment.

While the business may not be literally selling the newest or oldest inventory, it uses this assumption for cost accounting purposes. If the cost of buying inventory were the same every year, it would make no difference whether a business used the LIFO or the FIFO methods. But costs do change because, for many products, the price rises every year. One way to potentially conserve cash is to look for tax savings related to inventory costs. Any company that maintains inventory is required to identify that inventory under a permissible method such as specific identification, first-in, first-out (FIFO), or LIFO.

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As well, the LIFO method may not actually represent the true cost a company paid for its product. Usually, the weighted average cost provides a mean value for inventory and the cost of goods sold. It allows those items to stay normal during high or low price inflation.

While the majority of US GAAP companies choose FIFO or weighted average for measuring their inventory, some use LIFO for tax reasons. Companies using LIFO often disclose information using another cost formula; such disclosure reflects the actual flow of goods through inventory for the benefit of investors. Last in, first out (LIFO) is only used in the United States where any of the three inventory-costing methods can be used under generally accepted accounting principles. The International Financial Reporting Standards (IFRS), which is used in most countries, forbids the use of the LIFO method. For this reason, companies must be especially mindful of the bookkeeping under the LIFO method as once early inventory is booked, it may remain on the books untouched for long periods of time.

Experiences in other countries, especially in Europe, show that the process is more complex and lengthier than anticipated. U.S. companies can learn from the mistakes of its European predecessors. The transition to IFRS will imply a change in management reporting and, in some cases, in the format of data required.

FIFO

LIFO understates profits for the purposes of minimizing taxable income, results in outdated and obsolete inventory numbers, and can create opportunities for management to manipulate earnings through a LIFO liquidation. In tough times, management could be tempted to liquidate old LIFO layers in order to temporarily artificially inflate profitability. As an investor, you can tell whether a LIFO liquidation has occurred by examining the footnotes of a company’s financial statements. A tell-tale sign is a decrease in the company’s LIFO reserves (i.e., the difference in inventory between LIFO and the amount if FIFO was used).

Voluntary changes in inventory costing methods generally are
applied retrospectively for financial reporting purposes. For
taxation, entities generally may recognize resulting effects that
increase tax liability ratably over four years. LIFO does not have to be used to calculate cost
of goods sold or operating profit in the primary income statement as
long as there is an adjustment so that ending net income is calculated
on a LIFO basis. The IFRS-only balance sheet that was provided to the bank violated
the conformity rule because the non-LIFO information was not
supplemental, but rather the primary presentation of the financial
information.

LIFO vs. FIFO

For example, consider a company with a beginning inventory of 100 calculators at a unit cost of $5. The company purchases another 100 units of calculators at a higher unit cost of $10 due to the scarcity of materials used to manufacture the calculators. The company would report the cost of goods sold of $875 and inventory of $2,100. The total cost of goods sold for the sale of 350 units would be $1,700. Unlike IAS 2, US GAAP allows use of different cost formulas for inventory, despite having similar nature and use to the company. Therefore, each company in a group can categorize its inventory and use the cost formula best suited to it.

The
entity treats most of these changes retrospectively in accounting
through retained earnings. However, the Code and regulations require
the cumulative effects of inventory method changes to be treated
prospectively. In the case of changing from LIFO, for tax purposes,
the entity will generally spread the income effects caused by the
change in https://business-accounting.net/ the opening inventory valuation over future years. By
contrast, in accounting, the change is spread over past years, thus
affecting the deferred tax accounts of the entity. The LIFO reserve is an accounting term that measures the difference between the first in, first out(FIFO) and last in, first out(LIFO) cost of inventory for bookkeeping purposes.

Moreover, because write-downs can reduce profitability (by increasing the costs of goods sold) and assets (by decreasing inventory), solvency, profitability, and liquidity ratios can all be negatively impacted. As a result, firms that are subject to GAAP must ensure that all write-downs are absolutely necessary because they can have permanent consequences. In a principle-based accounting system, the areas of interpretation or discussion can be clarified by the standards-setting board, and provide fewer exceptions than a rules-based system. However, IFRS include positions and guidance that can easily be considered as sets of rules instead of sets of principles. At the time of the IFRS adoption, this led English observers to comment that international standards were really rule-based compared to U.K.

Therefore, we can see that the financial statements for COGS and inventory depend on the inventory valuation method used. As discussed below, it creates several implications on a company’s financial statements. Last-in First-out (LIFO) is an inventory valuation method based on the assumption that assets produced or acquired last are the first to be expensed. In other words, under the last-in, first-out method, the latest purchased or produced goods are removed and expensed first. Therefore, the old inventory costs remain on the balance sheet while the newest inventory costs are expensed first.

The U.S. is the only country that allows last in, first out (LIFO) because it adheres to Generally Accepted Accounting Principles (GAAP). The inherent characteristic of a principles-based framework is the potential of different interpretations for similar transactions. This situation implies second-guessing and creates uncertainty and requires extensive disclosures in the financial statements. They were rules-based, principle-based, business-oriented, tax-oriented … in one word, they were all different. With globalization, the need to harmonize these standards was not only obvious but necessary. IFRS does not recognize LIFO, yet taxpayers with
business operations outside the United States are often required to
provide restated financial information that complies with IFRS.

In addition, there is the risk that the earnings of a company that is being liquidated can be artificially inflated by the use of LIFO accounting in previous years. Most companies that use LIFO are those that are forced to maintain a large amount of inventory at all times. By offsetting sales income with their highest purchase prices, they produce less taxable income on paper.

An entity
makes retrospective application only for the direct effects of the
change (paragraph 10). However, indirect effects—for example,
bonuses—are reflected prospectively (paragraph 10). Under IFRS and ASPE, the use of the last-in, first-out method is prohibited. The inventory valuation method is prohibited under IFRS and ASPE due to potential distortions on a company’s profitability and financial statements.