FIFO vs LIFO in Accounting: What’s the Difference?

For businesses managing inventory, choosing the best inventory valuation method can save you money on taxes, optimise your financial statements, and improve your profitability tracking. The most common options are FIFO (First In, First Out) and LIFO (Last In, First Out), the former of which is catered for by accounting software platforms like Quickbooks.

Choosing the inventory valuation method that best aligns with your business and industry is an important accounting and financial decision for any business maintaining inventory. In this article, we’ll explain the differences between FIFO and LIFO, help you stay compliant, and empower you to make informed decisions tailored to your industry and needs

Key Takeaways

• FIFO and LIFO are the two most common inventory valuation methods. FIFO is allowed under both UK GAAP and IFRS, while LIFO is not permitted by either.
• FIFO stands for ‘First In, First Out,’ which means that the oldest inventory you received is sold first, while the newer inventory is sold later.
• LIFO stands for ‘Last In, First Out,’ which means that the most recent inventory you received is sold first, while the older inventory is sold later.
• FIFO typically results in higher net income and inventory values, while LIFO generally lowers both.

What Is Inventory Valuation?

An inventory valuation method is a system used by a business to determine the cost of its inventory and accurately report this cost on its financial statements. It provides businesses with a clear picture of their finances and enables potential investors or lenders to evaluate the business’ financial information.

Valuing inventory accurately can be challenging as its value can vary significantly based on when it was purchased, whether its value has depreciated and whether it’s been replaced by newer designs. As a result, businesses can use multiple valuation methods, but the two most common are LIFO and FIFO.

The method you choose can have a significant impact on your business’s inventory asset and expense values. In turn, this can impact your business’s cost of goods sold (COGS), gross profit, and bottom line, which can make your business appear more or less profitable to owners, investors, and lenders.

What Are FIFO and LIFO?

FIFO and LIFO inventory valuation methods might sound similar, but there are some significant differences to be aware of. The option you choose can potentially affect your business’ financial statement values, reported income, reported assets, and more.

What is FIFO?

The FIFO inventory valuation method is commonly used by businesses to determine the value of inventory on their financial statements. FIFO stands for ‘First In, First Out,’ which means that your company intends to sell the inventory items it acquired earlier before the inventory it acquired later.

The FIFO valuation method aligns with the physical flow of inventory, which makes it a logical choice for many businesses. Most companies want to sell the inventory they acquired earlier before the later inventory. This is because inventory can become obsolete or be replaced with newer designs, making it valuable to sell older inventory as quickly as possible.

For example, under FIFO, if you purchased inventory on 15 January and again on 30 January, you would sell the inventory you acquired first before selling the inventory you acquired on 30 January. You would also use the cost of inventory on 15 January to calculate your business’ COGS before the inventory was acquired on 30 January.

There are several pros and cons of FIFO that businesses should be aware of. These include:

For example, imagine a grocery store is trying to determine which inventory valuation method they’d like to use. They weigh the pros and cons of each option and decide to use the FIFO method because they want to sell their oldest stock first to avoid spoilage.

This improves their financial ratios and profitability more than LIFO would because the inventory cost is lower, which lowers the inventory expense on the income statement and enhances profit. It also minimises costs associated with replacing spoiled inventory, which further reduces costs and improves profitability.

What is LIFO?

LIFO stands for ‘Last In, First Out’ and is effectively the opposite of FIFO. With LIFO, businesses sell their newest inventory first, followed by their progressively older inventory, which makes LIFO the reverse of the physical flow of goods.

LIFO is a great option for businesses with non-perishable, durable, long-lasting inventory that the company believes can stand the test of time. Businesses selling things made of plastic, metal, wood, or a combination of those materials that undergo infrequent design changes are good candidates for LIFO.

While FIFO has a number of benefits (discussed above), LIFO also has some unique pros and cons as well. These include:

For example, a cosmetics brand with frequently updated product designs and/or packaging may choose to use LIFO as it wants to market and sell its newer cosmetic products quickly and at a higher price.

Is LIFO Allowed in the UK?

Unfortunately, LIFO isn’t allowed in the UK. Neither UK GAAP (Generally Accepted Accounting Principles) nor IFRS (International Financial Reporting Standards), the two major sets of financial regulations in the UK, allow the use of the LIFO inventory method.

As a result, UK businesses must use the FIFO method instead. This decision by the UK may seem controversial to businesses that are based in the US, where both methods are allowed, but are operating in the UK as well.

However, not permitting LIFO has the benefit of ensuring that all UK businesses track and value their inventory using the same method, which improves comparability and the ease of comprehension amongst investors and stakeholders. It also limits businesses’ ability to alter financial positions artificially to suit their goals.

How Do You Implement FIFO?

If your UK business isn’t already using the FIFO valuation method, you can begin implementing it at any time during the accounting period. The process of implementing FIFO is generally done by the business’s management or accounting team, and it requires careful planning and compliance with accounting standards.

Here’s a step-by-step guide to implementing FIFO:

1. Understand applicable regulations: In the UK, businesses must comply with either IFRS or UK GAAP, depending on whether they’re listed on a stock exchange. Listed companies are required to use IFRS. Non-listed companies can use either UK GAAP or IFRS. Both UK GAAP and IFRS require the use of FIFO and prohibit LIFO.
2. Understand the financial impact: Implementing FIFO for the first time will have an impact on your financial statements. Remember that in periods of inflation (which is the norm), FIFO results in lower COGS, higher profit, and higher inventory values when compared with LIFO.
3. Use accounting and inventory management software: In the modern age, software can handle many tedious and time-consuming tasks for accountants and management teams. Accounting and inventory management software can automate tracking and valuing inventory and match sales to the oldest inventory on the books, saving you time and administrative costs.
4. Document the change: Effective accounting is all about documentation. When you implement FIFO, document how you did it, what methods you used, when it was implemented, etc. This can help you defend your business and your financial statements in case of an audit down the road. Potential investors may also want to know this information. You should disclose this change in your financial statement footnotes.
5. Consult a professional accountant: As always, consulting a professional can be incredibly valuable. An accountant can help you avoid issues with using FIFO, ensure you stay compliant with regulations, and optimise your financial statements for both investors and taxes.