Definitions of FIFO and LIFO
FIFO and LIFO are two of the cost flow assumptions used by U.S. companies with inventory items.
FIFO moves the first/oldest costs from inventory and reports them as the cost of goods sold and leaves the last/more recent costs in inventory.
LIFO moves the latest/more recent costs from inventory and reports them as the cost of goods sold and leaves the first/oldest costs in inventory.
A U.S. company may switch from FIFO to LIFO. However, after the switch the company must use LIFO consistently.
Reason for Using FIFO Instead of LIFO
If a U.S. corporation’s cost of inventory items are continuously increasing and the corporation has been experiencing operating losses and negative taxable income, the use of FIFO means matching its oldest/lower costs with its current sales. The result is a larger gross profit and a positive operating income.
Reason for Using LIFO
If a U.S. corporation’s costs of inventory items are continuously increasing, a profitable U.S. corporation will have lower income tax payments with LIFO. This results from matching the most recent higher costs of its items to the most recent sales. (The higher cost of goods sold means lower net income and lower taxable income than FIFO.)
Another reason for a company to use the LIFO cost flow assumption is to improve the matching of costs with sales. If the company had matched the old low costs using FIFO, the company would show a greater profit that was partly caused by merely holding some old inventory items.
