Which inventory method results in the highest net income during periods of falling prices?

What is FIFO vs. LIFO?

FIFO and LIFO are two methods of accounting for inventory purchases, or more specifically, for estimating the value of inventory sold in a given period.

Table of Contents

• FIFO vs. LIFO Accounting – Inventory Valuation Methods
• What is FIFO?
• What is LIFO?
• FIFO vs. LIFO: Advantages and Disadvantages Chart
• LIFO vs. FIFO: Net Income Impact Examples
• Increasing Inventory Costs
• Decreasing Inventory Costs
• FIFO vs. LIFO Calculation Example

FIFO vs. LIFO Accounting – Inventory Valuation Methods

What is FIFO?

FIFO is an abbreviation for “First In, First Out.”

Under the FIFO approach of accounting, the inventory purchased earlier is the first to be recognized and expensed on the income statement, within the cost of goods sold (COGS) line item.

Outside of the U.S., only FIFO is permitted under IFRS, so FIFO tends to be the prevalent inventory valuation method for international companies.

What is LIFO?

Alternatively, LIFO is an abbreviation for “Last In, First Out.”

LIFO, unlike FIFO, recognizes the more recently purchased inventories ahead of those purchased earlier – i.e. the most recent inventory purchases are the first to be sold.

Under U.S. GAAP, LIFO is permitted, making the FIFO vs LIFO decision a discretionary decision for U.S. companies.

Hence, many U.S. companies will present their financials abiding by the LIFO method on their filings and financial statements with the SEC but switch to FIFO for their international operations (e.g. subsidiaries).

FIFO vs. LIFO: Advantages and Disadvantages Chart

The importance of FIFO vs. LIFO is due to the fact that inventory cost recognition directly impacts a company’s current period net profits (and taxes).

LIFO vs. FIFO: Net Income Impact Examples

Increasing Inventory Costs

To further expand upon the summary chart, the rules are as follows:

• If Inventory Costs Increased ➝ Lower COGS Recorded under FIFO (Higher Net Income)
• If Inventory Costs Increased ➝ Higher COGS Recorded under LIFO (Lower Net Income)

In this situation, the inventory purchased earlier is less expensive compared to recent purchases.

Since the inventory purchased first was recognized, net income will thus be higher in the current period.

With that said, if inventory costs have increased, the COGS for the current period are higher under LIFO.

Decreasing Inventory Costs

As for declining inventory costs, the impacts of FIFO vs LIFO are:

• If Inventory Costs Decreased ➝ Higher COGS Under FIFO (Lower Net Income)
• If Inventory Costs Decreased ➝ Lower COGS Under LIFO (Higher Net Income)

By contrast, the inventory purchased in more recent periods is cheaper than those purchased earlier (i.e. older inventory costs are more expensive).

Therefore, considering the older, more expensive inventory was recognized, net income is lower under FIFO for the given period.

Conversely, COGS would be lower under LIFO – i.e. the cheaper inventory costs were recognized – leading to higher net income.

FIFO vs. LIFO Calculation Example

Let’s assume that a company has sold 100 units of t-shirts in the current period at the prices listed below:

• Recent Inventory Costs: $20
• Earlier Inventory Costs: $10

The trend above shows that the more recent inventory costs have increased versus earlier costs.

Under the two methods, FIFO and LIFO, the following could be recognized as COGS in our example:

• FIFO: $10 * 100 = $1,000
• LIFO: $20 * 100 = $2,000

Since inventory costs have increased in recent times, LIFO shows higher COGS and lower net income – whereas COGS is lower under FIFO, so net income is higher.