Question

A company's business (product manufactured or sold) does not have to match its choice of inventory method (exceptions are, a car dealer or a diamond merchandiser because each product unit is unique). Therefore, a company can choose to use either FIFO or LIFO regardless of the product it manufactures or sells. If that's the case, what could be some of the reasons (other than companies that are required to use one or the other) a company would choose FIFO over LIFO or vice versa? Do you agree with those reasons, or do you think they just add unnecessary complexity to the accounting process?

Answer 1

Reason for Using FIFO Instead of LIFO

• If a 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.
• FIFO inventory accounting provides more accurate inventory valuations since the assumption is the items remaining in inventory were purchased at more recent--and typically higher--prices. Under FIFO the value of inventory is higher compared to LIFO.

Reason for Using LIFO

• If the costs of inventory items are continuously increasing, a profitable 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.
• Think of LIFO accounting as providing a deferred tax advantage. On the flip side, LIFO also results in a weaker balance sheet since the value of your inventory is lower.
• Choosing an appropriate method is a practice of experience and understanding of business and it's transactions. The analysis shows that choosing an appropriate method reduces complexities rather than creating them. Thus, it more often simplifies the accounting process.