FIFO and LIFO are two methods used in managing inventory and financial matters involving the amount of money a company has to have tied up within inventory of produced goods, raw materials, parts, components, or feedstocks.
FIFO (First-In, First-Out) assumes that the oldest products in a companys inventory have been sold first and goes by those production costs. This means that the first items entered into your inventory are the first ones you sell. FIFO is often used by companies that sell perishable goods, such as supermarkets, to ensure that goods with earlier expiration dates are sold before goods with later expiration dates. FIFO often results in higher net income and higher inventory balances on the balance sheet. However, this results in higher tax liabilities and potentially higher future write-offs if that inventory becomes obsolete.
LIFO (Last-In, First-Out) assumes that the most recently produced items are recorded as sold first. This means that the most recent items entered into your inventory will be the ones to sell first. Under the LIFO method, assuming a period of rising prices, the most expensive items are sold. This means the value of inventory is minimized and the value of cost of goods sold is increased. Under the LIFO method, expenses are highest. This means taxable net income is lower under the LIFO method and the resulting tax liability is lower under the LIFO method. LIFO is used only in the United States, which is governed by the generally accepted accounting principles (GAAP) . LIFO is often used by companies that want to reduce their tax liability. However, LIFO often does not represent the actual movement of inventory and results in lower net income compared to other methods.
The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entitys taxable income has been deferred by using the LIFO method.
In general, the inventory valuation method a company chooses will depend on its tax situation, inventory flow, and record-keeping requirements.
