What is the difference between LIFO and FIFO, and how does the choice change the financial statements?
FIFO sends the oldest costs to COGS, and LIFO sends the newest. When costs rise, LIFO gives higher COGS, lower profit and taxes, more cash after tax, and inventory carried at older, lower costs. Falling costs reverse this. IFRS bans LIFO.
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LIFO and FIFO are two ways of deciding which costs go to cost of goods sold. FIFO, first in first out, assumes the oldest units are sold first. LIFO, last in first out, assumes the newest units are sold first. The choice changes cost of goods sold, so it also changes profit and the inventory number on the balance sheet. Which method gives the higher profit depends on what prices are doing.
What holds it back
The definitions are right, but "it depends on prices" never commits to a direction. There's no example, no mention of taxes, and nothing on which accounting rules allow LIFO.
LIFO and FIFO are two ways of deciding which costs go to cost of goods sold when a company bought the same item at different prices. FIFO, first in first out, assumes the oldest units are sold first. LIFO, last in first out, assumes the newest units are sold first. It's an accounting assumption about cost, not about which physical units leave the warehouse. Take an example. A company buys one unit for $10, then another for $12, and sells one unit for $20. Under FIFO, cost of goods sold is $10, gross profit is $10, and the unit left in inventory is carried at $12. Under LIFO, cost of goods sold is $12, gross profit is $8, and inventory is carried at $10. So when costs are rising, LIFO gives higher cost of goods sold, lower profit and lower taxes. FIFO does the reverse: higher profit, higher taxes, and a balance sheet inventory that's closer to current cost. If costs are falling, all of that flips. LIFO is allowed under US GAAP but not under IFRS, so it's mainly a US issue.
LIFO and FIFO are two ways of deciding which costs go to cost of goods sold when a company bought the same item at different prices. FIFO, first in first out, assumes the oldest units are sold first. LIFO, last in first out, assumes the newest units are sold first. It's an accounting assumption about cost, not about which physical units leave the warehouse. Take an example. A company buys one unit for $10, then another for $12, and sells one unit for $20. Under FIFO, cost of goods sold is $10, gross profit is $10, and the unit left in inventory is carried at $12. Under LIFO, cost of goods sold is $12, gross profit is $8, and inventory is carried at $10. So when costs are rising, LIFO gives higher cost of goods sold, lower profit and lower taxes. At a 25% tax rate, the $2 of lower profit saves $0.50 of tax, so LIFO leaves the company with more cash even though it reports less profit. FIFO does the reverse: higher profit, higher taxes, and a balance sheet inventory that's closer to current cost. If costs are falling, all of that flips. LIFO is allowed under US GAAP but not under IFRS, so it's mainly a US issue. When I compare a LIFO company with a FIFO one, I'd put them on the same basis. LIFO companies disclose a LIFO reserve, which is the gap between inventory at FIFO and at LIFO, and adding it back to inventory does that. I'd also watch for a LIFO company running its inventory down. Selling old, cheap layers gives profit a one-time lift that won't repeat.
The numbers, step by step
Two units bought at $10 and then $12, one unit sold for $20, and a 25% tax rate.
- FIFO gross profit$20 - $10
- $10
- LIFO gross profit$20 - $12
- $8
- Lower profit under LIFO$10 - $8
- $2
- Tax saved under LIFO$2 × 25%
- $0.50
What the interviewer listens for
- Can you define both without mixing them up?
- Do you state the direction for rising costs and say it flips when costs fall?
- Do you cover the income statement, the balance sheet and taxes?
- Do you know LIFO is not allowed under IFRS?
Common mistakes
- Reversing the direction.With rising costs LIFO has the higher cost of goods sold and the lower profit, not FIFO.
- Saying LIFO is worse for the company because profit is lower.Lower taxable income means less tax paid, so cash flow is better when costs are rising.
- Describing it as the physical flow of goods.It's a cost assumption, and the units that leave the warehouse can be any units.
- Forgetting the balance sheet.Under LIFO in a period of rising costs, inventory is carried at old, lower costs.
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- A company raises $100 of debt to buy equipment. Walk me through the three statements at the time of purchase.
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