However, businesses might no longer be allowed to use the LIFO method. The Obama administration proposed to repeal the LIFO method of accounting for inventories. The proposal would not allow the use of the LIFO inventory accounting method for federal income tax purposes. Taxpayers that currently use the LIFO method would have to write up their beginning LIFO inventory to its FIFO value in the first taxable year beginning after 12/31/11.
Sunday, March 14, 2010
FIFO and LIFO
Okay so this past week I learned about LIFO and FIFO. LIFO and FIFO are two ways for a business to count inventory. LIFO stands for last in first out, meaning that the inventory acquired last is going to be sold before older inventory. FIFO stands for first in fist out, meaning that the inventory acquired first will be sold before inventory acquired later on. For example, say a business bought one tv on 2/10/09 for $200, another tv on 5/11/09 for $220, and a final tv on 7/23/09 for $250. Then, say two of the three tvs were sold, now the business does not necessarily know which two tvs it sold and therefore the business will use either the FIFO and LIFO method (there is one other method for inventory counting but I'm not including it in this blog). Using the FIFO method, the business assumes that the customers bought the tvs the business acquired on the 2/10 and 5/11. This means the total value of the costs of goods sold would be $420 and the ending inventory would be $250. Under the LIFO method, the business assumes that the customers bought the tvs the business acquired on 5/11 and 7/23. This means the total value of the cost of goods sold would be $470 and the ending inventory would be $200.The FIFO method has market-priced assets (inventory at current prices), undervalued costs (the costs of goods sold are at newer prices), overstated net income (revenues minus costs/expenses), higher earnings per share which leads to higher taxes and smaller cash flow. The FIFO method is considered the more conservative method of the two. On the other hand, the LIFO method creates undervalued assets (inventory at old prices), overvalued costs (costs of goods sold at newer prices), understated net income (revenue minus costs/expenses), higher earnings per share which leads to lower taxes and greater cash flow.
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That's really interesting! So,were FIFO/LIFO defined originally for tax purposes, or did accountants create them for some other reason?
ReplyDeleteWhen you say FIFO method overstates net income and LIFO understates it, is that because you assume increasing prices? If there was deflation in the markets a firm buys from/sells to, would the effects on net income be the opposite?
Also--last question, I promise--with better technology, will these methods become obsolete? For instance, if every piece of inventory had a unique barcode, it seems as if a firm could keep a record of exactly how much they paid for inventory.
I have no idea what FIFO and LIFO were originally for, I just know they're two of the three methods of counting inventory. And it only understates net income when prices are increasing, which is why in my example as time went by I had the prices increase. I'm pretty sure if instead there was deflation, then FIFO wouldn't be the conservative method. The FIFO and LIFO method are only used for periodic inventory systems which is when a company doesn't record the changes in inventory until the end of the fiscal period. The system using barcodes is called the perpetual inventory method and it records the change in inventory immediately after the good is purchased. The perpetual system has no need for FIFO and LIFO because it records what exact goods are sold, so yeah if technology continues to improve in that degree there probably would eventually be no need for FIFO and LIFO.
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