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LIFO vs. FIFO Reported Income

The Internal Revenue Service and state taxing authorities require businesses to report their income and losses for each fiscal period. A business's income tax rate and liability are based on its income report, so expense deductions and accounting methods can have a significant effect on the taxes it must pay. For some businesses, the choice between the last-in, first-out method of accounting, called LIFO, and the first-in, first-out method, called FIFO, makes a considerable difference in how much they can deduct.

  1. Inventory Costing

    • When a business reports its income, it must deduct all of its operating expenses to avoid having to pay higher taxes. A major source of expenses -- especially for retail businesses -- is the cost of inventory. Inventory is all of the goods a business purchases for resale to its customers. There are multiple methods available to account for this expense. The method a business opts to use is important, as it can substantially affect the firm's reported income, tax expenses, and investor outlook. This is because not all inventory purchases are the same, as rising prices generally mean that more recent purchases are more expensive than less recent purchases. This effect of rising prices on inventory costs is critical to the difference between the FIFO and LIFO costing methods.

    Last-In, First-Out Method

    • One method a business can use to account for its inventory is called the last-in, first-out method. In LIFO, the business assumes that the last, or most recent, units of inventory it purchases are also the first that it sells to its customers. This assumption has two significant impacts on the way the business prepares its major financial statements. First, the inventory that the company recognizes as an expense at the end of the fiscal period is the most recently purchased inventory, and probably more expensive than the older inventory. In LIFO, this means that the income statement reports greater inventory expenses and less net income. Second, the inventory that the balance sheet reports as remaining in stock has less value in LIFO, as it consists of the least recently purchased, or oldest, inventory.

    First-In, First-Out Method

    • The first-in, first out method, FIFO, works in the opposite order of LIFO. As a result, the FIFO method affects financial statements differently than the LIFO method. In FIFO, the company uses the value of its least recently purchased units to determine its reported inventory expenses. As a result, reported inventory expense is less in the FIFO method than in the LIFO method. This smaller inventory expense results in a higher reported net income. Just as with LIFO, the decision to use FIFO also affects the balance sheet. In FIFO, the remaining inventory, reported as an asset at the end of the period, consists of the most recently purchased inventory. This means that the value of the inventory remaining in stock will usually be greater in FIFO than in LIFO.

    Effects on Reported Income and Taxes

    • The choice of either the LIFO or FIFO accounting method results in some difference in a company's reported income. Because FIFO results in a higher reported net income, it often comes with greater tax liability at the end of the year. The Internal Revenue Service allows businesses to choose whether they want to use LIFO, FIFO or another accounting method when deducting inventory expenses, but requires that the method is consistent from year to year. Even though LIFO provides a more conservative income statement and reduces a business's tax burden, the Journal of Accountancy and PricewaterhouseCoopers both report that businesses are actually moving away from LIFO to comply with International Financial Reporting Standards.

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