Last updated on Jun 6, 2024
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What are FIFO and LIFO?
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How do FIFO and LIFO affect your income statement?
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How do FIFO and LIFO affect your balance sheet?
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How do FIFO and LIFO affect your cash flow and working capital?
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How do FIFO and LIFO affect your taxes?
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How to choose between FIFO and LIFO?
FIFO and LIFO are two common methods of inventory valuation that can have a significant impact on your cash flow and working capital. In this article, you will learn what FIFO and LIFO mean, how they differ, and how they affect your financial statements and tax obligations.
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1 What are FIFO and LIFO?
FIFO stands for first-in, first-out, which means that the oldest inventory items are sold first. LIFO stands for last-in, first-out, which means that the newest inventory items are sold first. These methods are based on the assumption that the cost of inventory changes over time due to inflation, market fluctuations, or other factors.
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2 How do FIFO and LIFO affect your income statement?
The choice of inventory valuation method affects your cost of goods sold (COGS), which is the direct cost of producing or acquiring the goods that you sell. COGS is deducted from your sales revenue to calculate your gross profit, which is a measure of your profitability. If the cost of inventory rises over time, FIFO will result in a lower COGS and a higher gross profit than LIFO, and vice versa.
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In period of rising prices, FIFO (as compared to LIFO), produces a lower cost of goods sold (COGS). LIFO is a better measurement of income than FIFO which is a better measurement for the Balance Sheet. With LIFO Conformity Rule, if a company uses LIFO for income tax, it must also uses LIFO for financial reporting to comply with governmental regulations. Since FISO presumes earliest merchandises are sold first, what's left in the ending inventory is the most recent purchases, henceforth, the most up-to-date cost. With LIFO, since most up-to-date COGS are reported, LIFO is considered a better measure of income than FIFO. All of these comply with GAAP under SEC authority, Financial Accounting Standards Board (FSAB), & IFRS internationally.
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3 How do FIFO and LIFO affect your balance sheet?
The choice of inventory valuation method also affects your inventory balance, which is the value of the goods that you have in stock at the end of the accounting period. Inventory is an asset that represents your investment in the goods that you sell. If the cost of inventory rises over time, FIFO will result in a higher inventory balance than LIFO, and vice versa.
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Since Inventory is the Current Asset on the Balance Sheet which shows resources of Asset = resources of Liability + resources of Owner Equity, that's how FIFO & LIFO can affect inventory as the current asset on the Balance Sheet whose equation A = L + OE. Unlike Income Statement which shows company's operations over a period of time, Balance Sheet measures company's financial position at a point in time -- specified date. Besides the Balance Sheet, ratio analysis identifies company's strength and weakness & to forecast future performance. Typical ratios are Liquidity (measurement of short-term obligations), Capital Adequacy (financial leverage), Asset Quality (asset management) & Earning (profitability).
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4 How do FIFO and LIFO affect your cash flow and working capital?
Cash flow is the amount of money that flows in and out of your business over a period of time. Working capital is the difference between your current assets and current liabilities, which reflects your ability to meet your short-term obligations and fund your operations. If the cost of inventory rises over time, FIFO will result in a higher cash flow and working capital than LIFO, because you will pay less taxes on your higher gross profit and have more inventory value to sell or use as collateral. LIFO will result in a lower cash flow and working capital than FIFO, because you will pay more taxes on your lower gross profit and have less inventory value to sell or use as collateral.
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5 How do FIFO and LIFO affect your taxes?
The choice of inventory valuation method also affects your taxable income, which is the amount of income that is subject to tax. Taxable income is calculated by subtracting your expenses, including COGS, from your revenue. If the cost of inventory rises over time, FIFO will result in a higher taxable income than LIFO, and vice versa. Therefore, FIFO will result in a higher tax liability than LIFO, and vice versa.
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6 How to choose between FIFO and LIFO?
When it comes to deciding which inventory valuation method is best for your business, there is no one-size-fits-all answer. Factors such as industry, market conditions, inventory turnover, and accounting standards all play a role in the decision. FIFO may be advantageous in that it reflects the current market value of your inventory and matches sales revenue with the most recent costs of production or acquisition. However, it may also overstate profitability and tax liability in times of rising costs, and may not accurately reflect the actual flow of goods in your business. On the other hand, LIFO may be beneficial in that it reflects the actual flow of goods in your business and matches sales revenue with the most recent costs of production or acquisition. However, it may also understate profitability and inventory value in times of rising costs, and may not reflect the current market value of your inventory. Ultimately, it is best to consult with an accountant or financial advisor to determine which inventory valuation method is most suitable for your business objectives and compliance requirements.
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As per IFRS using LIFO is not allowed but If we sold full inventory profit will be same. Hence I don't think so it will impact the profitability.
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