Your inventory value relates to products that are not sold and that are sitting in your inventory at the beginning or end of a financial period. The ending inventory value of one period should always be equal to the beginning inventory value of the next period. Sharon Barstow started her career in investment banking and then crossed over to the world of corporate finance as a financial analyst. She specializes in banking and corporate finance topics to include treasury management, financial analysis, financial statement analysis, corporate finance and FP&A.
Inventory Methods That Result in the Lowest Taxable Income in a Period of Decline
However, FIFO can give rise to paper profits, while specific identification can give rise to income manipulation. Most companies prefer the FIFO method for inventory accounting, as it provides a clearer reflection of ending inventory values and higher net income, which can be beneficial in stable economic conditions. The LIFO method, however, is advantageous for businesses with large inventories during periods of inflation, as it reduces taxable income by reflecting higher costs of goods sold. If inflation were nonexistent, then all inventory valuation methods would produce the same results. When prices are stable, the bakery from our earlier example would be able to produce all of its bread loaves at $1, and LIFO and FIFO would both give us a cost of $1 per loaf.
In periods of price decline, the best method for a lower net income, and therefore lower income taxes, is the method that renders the highest value for the cost of goods sold. As our example shows, FIFO renders a value of $1,000 for cost of goods sold, and LIFO renders a value of $500. The average cost method renders a value that falls midway between both at $750. In periods of price decline, the best methods for a lower net income are FIFO the inventory costing method that results in the lowest taxable income in a period of rising costs is: or average cost. If prices were stagnant, you wouldn’t need to value inventory, but that’s not the case.
- The first in, first out (FIFO) method assumes that the first unit making its way into inventory–the oldest inventory–is sold first.
- 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.
- Because of high inflation during the 1970s, many companies switched from FIFO to LIFO for tax advantages.
- Serious investors must understand how to assess the inventory line item when comparing companies across industries—or companies in their own portfolios.
Major Differences—LIFO and FIFO (During Inflationary Periods)
The key point from a theoretical economic perspective is that the cost of an item is its replacement cost. Consider the price one would charge a friend who wanted one of the available units under the assumption of not making a profit or taking a loss. One would charge a friend the cost one would incur to replace the unit. Under the historical cost model, only the balance sheet or income statement can reflect this $110, but not both. As illustrated by Exhibit 2, an accountant faces a trade-off as to where to place the more recent (higher) current costs. Under FIFO, the balance sheet reflects inventory at the current cost of $110.
It is also a major success factor for any business that holds inventory because it helps a company control and forecast its earnings. For investors, inventory is an important item to analyze because it can provide insight into what’s happening with a company’s core business. However, the LIFO method may not represent the actual movement of inventory.
Top 4 Inventory Costing Methods and How They Work
LIFO usually doesn’t match the physical movement of inventory because companies are more likely to try to move older inventory first. However, car dealerships or oil companies may try to sell items marked with the highest cost to reduce their taxable income. Assuming that prices are rising, this means that inventory levels are going to be highest because the most recent goods (often the most expensive) are being kept in inventory.
If you’re based in the US but you sell internationally, you have to use FIFO, which at least makes the decision making process easier. As you can see, the COGS are attributed to the purchases made in August and September. As you can see, the COGS are attributed to the purchases made in July and August.
What Types of Companies Often Use LIFO?
Using the example above, if you sell 500 ears of corn, the cost of goods sold is $1 per ear, or $500, and the cost of inventory on the books is $2 per ear, or $1,000. While LIFO produces a lower tax liability, the FIFO method tends to report a higher net income, which can make the company more attractive to shareholders. It also reports a higher value for current inventory, which can strengthen the company’s balance sheet. For this reason, companies must be especially mindful of the bookkeeping under the LIFO method; once early inventory is booked, it may remain on the books untouched for long periods of time. Companies like retailers and auto dealerships use LIFO to manage large inventories. It helps reduce taxable income and increase cash flow when expenses rise.
4: Effects of Choosing Different Inventory Methods
The inventory costing method you choose can have a big impact on taxes as well as valuation. Note that all the numbers in this scenario are equal to 110% of what they were before the 10% price change. The LIFO inventory method results in all stakeholders having their share adjusted by the same amount—the change in price. If, however, an entity was forced to use FIFO, COGS would be $100, and pre-tax income would be $32. At the 30% tax rate, the tax bill would be $9.60 with after-tax earnings of $22.40. But the company would still need to replace the unit of inventory that was sold.
LIFO vs. FIFO: Taxes
- 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 (GAAP).
- Therefore, the older inventory is left over at the end of the accounting period.
- It would also reduce economic growth and penalize industries that typically keep more inventory on hand, such as retailers of durable goods (Muresianu and Durante 2022).
- Companies that opt for the LIFO method sell their most recent inventory first, which usually costs more to obtain or manufacture.
- The last-in, first-out (LIFO) method assumes that the last unit making its way into inventory–the newest inventory–is sold first.
However, this also results in higher tax liabilities and potentially higher future write-offs—in the event that that inventory becomes obsolete. In general, for companies trying to better match their sales with the actual movement of product, FIFO might be a better way to depict the movement of inventory. Working out the value of your inventory isn’t as simple as basic addition but it doesn’t have to be complicated either. The biggest challenge is choosing the right inventory costing methods for your business and when to use them.
Inventory is one of the largest costs for non-service-oriented businesses. It is defined as those assets on the balance sheet that are intended to be sold or used in the current year. While the calculation of inventory is rather straightforward, several methods are used to value inventory, which can greatly affect the income statement and subsequently the amount a business pays in income taxes.
As in any model, the scenario presented above relies on several assumptions that may not always be present. We believe, however, that the assumptions underlying the model represent a likely scenario in many industries. First, the model assumes that sales prices are marked up at a specified percentage above cost, which may not always be the case. Second, the model primarily deals with an inflationary period in which prices and costs are expected to rise. While this is a very typical scenario in many industries, it is not necessarily expected to occur in every industry and in every time period.
