Inventory accounting is an important part of any business. Inventory plays a big part in a company’s cash flow. But inflation and taxes can affect inventory values. Depending on what accounting method you use, your company could report what is called ‘illusionary profits’. These are profits that are reported on financial statements but after taxes, the actual profits are less. When it comes to inventory accounting, there are two main accounting methods that are used: FIFO and LIFO.
FIFO and LIFO accounting methods manage the financial end of a company’s inventory. Each one has its own benefits and disadvantages and one of them is actually preferred over the other by most businesses. So what are some of the differences in the two methods? Why is inventory so important? If you are a business owner, you need to know these accounting methods in order to figure out which one will benefit you the most.
Why Is Inventory Important?
Inventory is the physical assets of a company that is intended for sale or for the manufacture of products for sale. Inventory is constantly changing as quantities are sold and replenished. A company’s inventory is important on financial statements because it represents a large amount of the company’s assets. That value is determined by which accounting method the company uses.
Why are there different inventory accounting methods instead of just one? Because the cost and value of inventory is influenced by the cost of inflation. Over time, prices tend to rise due to inflation in the economy. Inventory that was purchased at one price may gain in value due to inflation. To rectify this, different accounting methods are used. Otherwise, inventory may be appraised incorrectly which could cause a problem with a company’s profits. In a perfect world, there would be no inflation and thus no need for separate accounting methods.
Different accounting methods can have an impact on the cost of inventory, monthly statements, and cash flow. LIFO and FIFO both have their advantages and can change the value of inventory to fit a company’s needs.
What Is FIFO?
FIFO stands for first-in, first-out. What this means is that the first item that comes into a warehouse (and the oldest) will be the first item shipped out. FIFO is a more accurate representation of the flow of physical items in and out through a distribution center. It is a common accounting method where there are many identical items being shipped.
Companies generally ship the oldest stock in inventory to prevent the items from deteriorating or expiring (such as with perishable goods). This allows the inventory to be continually rolled or turned-over which keeps the oldest ready to be shipped.
FIFO is a better accounting method to use in times when the economy has stable prices. However, when inflation is high, using FIFO results in what is called “inventory profits”. These are profits that come just from holding onto inventory and increasing physical assets. But it does not provide the best results for matching costs and revenues.
In times of inflation, smaller companies will use FIFO because the value of their inventory is higher and it makes their financial statements look better. As the first-in inventory is sold, the newer inventory, which is more expensive, remains on the company’s financial records. A company can use this to their advantage for things such as attracting more business, mergers, increasing value of stocks, or acquiring a loan.
The main disadvantage to using FIFO instead of LIFO is that at the end of the year, the company will have to pay more taxes due to the ‘profits’ recorded on their statements. This is why after a company experiences some growth, they usually switch to LIFO.
What Is LIFO?
LIFO stands for last-in, first-out. How this works is that a company records its inventory as the last items that were purchased are the first items sold. Older inventory is left over. This method is also sometimes referred to as FILO (first-in, last-out). As inflation raises prices in the economy, the LIFO method records the sale of the most expensive items in inventory first. This is not an accurate representation of the actual flow of physical items through inventory. On paper this will show a decrease in profits but it also helps to reduce taxes because a company is not recording a false profit (which is the case with FIFO). In fact, LIFO has been the preferred accounting method since the early 1970’s. During that decade, the U.S. experienced its first major rise in inflation in modern times which has continued steadily for almost forty years now.
The theory in using this method is that costs will either remain the same or increase. Most of the companies that use LIFO experience a rise in inventory costs every year. LIFO is a better approach to matching current costs with current revenues. As inventory gets sold, it should be replaced with higher priced items. Companies that use LIFO do so merely for tax purposes so that they can increase cash flow over a long period.
The drawback to LIFO is that it must also be used on financial statements and reports. This means that companies will show less net profit than if they used FIFO. In terms of business, this could interfere with future loans and attracting clients or partners.
LIFO has been the preferred accounting method since the early 1970’s. The U.S. experienced its first major rise in inflation during modern times which has continued steadily for almost forty years now.
One aspect of using LIFO is that as older inventory gets left behind, it must eventually be liquidated. Sometimes companies have trouble replacing existing inventory, need cash flow, or must make room for newer inventory. If prices have continued to rise, then the older inventory will have a lower value. The problem is that if the company liquidates this older inventory, it must go on their financial statements as net profits and will increase their taxes. This is why some companies have a stockpile of older inventory sitting in warehouses becasude to get rid of it would have undesirable results.
Main Differences between FIFO and LIFO
When deciding which accountign method to use fo rinventory, you have to look at the major differences between FIFO and LIFO. With FIFO, you get a better estimation of the value of inventory. While it can be used to increase net profits, it will also increase the amoutn of taxes a company will have to pay in.
LIFO is not a good indicator of inventory value because some of the inventory may be years old, deteriorated beyond use, or not compatible with newer versions. So the value will probabaly be lower than current prices. This decreases net profits which also effects net shares in the company. But using LIFO also gives you a break on taxes at the end of the year.