Definition of FIFO and LIFO
FIFO and LIFO pertain to the flow of products’ costs out of inventory to the cost of goods sold that is reported on the income statement.
First, if the costs of the inventory items never change, there will be no difference whether FIFO or LIFO is used. The reason is that the first costs (oldest costs) will be the same as the latest or recent costs. On the other hand, if the costs of the inventory items are increasing often and significantly, the differences in profits and inventory values between FIFO and LIFO will be significant.
Example of LIFO with Increasing Costs
In the U.S., LIFO is considered to be better when the costs of inventory items are changing. The reason is LIFO is matching the latest costs of products with the recent sales revenues. In addition, the U.S. tax rules also allow for either FIFO or LIFO, but require the same cost flow assumption be used on both the company’s tax return and on the company’s financial statements. With inflation being the norm, profitable companies using LIFO are matching the higher recent costs with the recent revenues and will be reporting lower taxable income and remitting smaller income tax payments.
