Introduction
The choice of inventory costing method is an important one for companies since the consequence of the choice is apparent in both the balance sheet and the income statement. In periods of rising prices, companies choosing the income-reducing method of Last-in-First-out (LIFO) also leave the lower earlier prices in their inventory values.
This results in inventory values in the balance sheet that are based on the older prices and hence this understates the current assets of the company. Thus, in times of rising inventory prices, the LIFO method results in lower net incomes and also lower values in the current assets. The only advantage to choosing this method is the lower tax expenses based on the lower income. The American tax code requires the use of the LIFO method for financial reporting purposes if that method is used for tax purposes. When used for tax purposes, LIFO with its lower reported incomes correspondingly results in substantial tax savings for companies with large amounts of inventories, typically most large merchandising and manufacturing companies in the economy.
FIFO vs. LIFO
Under FIFO, the goods sold are the oldest produced or purchased by the company. LIFO is simply the opposite -- the goods sold are the most recently produced or purchased.
With both FIFO and LIFO, we are more concerned with cost allocation than the actual flow of goods. We're trying to effectively tie our costs together and may not even know about the inventory's physical flow.
LIFO, on the other hand, leads us to believe that companies want to sell their newest inventory, even if they still have old stock sitting around. LIFO's a very American answer to the problem of inventory valuation, because in times of rising prices, it can lower a f ...