The Balance Sheet : LIFO and FIFO
September 14, 2007
We said that the balance sheet records only what was paid for assets, not what they’re worth. One of the trickiest aspects of the balance sheet for a nonaccountant is the problem of what actually was paid for the inventory. Here’s the problem: Houston Sash & Door buys inventory (raw lumber) throughout the year. Also throughout the year Houston Sash & Door converts the lumber to finished products and sells them. Let’s assume that the cost of the lumber keeps rising during the year (a pretty good assumption in inflationary times).
How do we know if the lumber on hand on December 31 was the “cheap” lumber bought on January 2, 2003, or the more expensive lumber bought on December 31, or an amalgam of all of the lumber purchases throughout the year? It’s impossible to tell for sure unless you tag each item, but your intuition would tell you that it’s more likely that the lumber purchased last is the lumber that was still around on December 31. In other words, the first lumber in was the first to go out, or FIFO (first in, first out). That’s what your intuition would tell you, but accountants aren’t necessarily guided by intuition. Quite the contrary. Accountants are allowed to assume that the last lumber bought was the first lumber sold, or LIFO (last in, first out). Does all this affect the financial statements? It does. Enormously.
If we use the LIFO method, we’re saying the inventory that appears on the balance sheet is the “cheap” inventory bought on January 2. As a result, the inventory appearing on the balance sheet is lower, which makes the net worth of the business lower. If we use the FIFO method, the reverse is true; FIFO results in a higher-priced inventory and a greater net worth.
Let’s take a look at the income statement in Table 2. The way in which gross profit is computed is directly, but subtly, influenced by whether LIFO or FIFO is used. As you can see, gross profit is derived by subtracting cost of goods sold from sales revenue:
Sales revenue - costs of goods sold = gross profit
Cost of goods sold is derived by adding the beginning inventory (the inventory on hand at the start of the year) to the cost of inventory purchased during the year and subtracting the cost of the ending inventory (the inventory on hand at the end of the year) as follows:
Beginning inventory + purchases of inventory during the year - ending inventory = cost of goods sold
This means that if the ending inventory is greater, the cost of goods sold is smaller. If the cost of goods sold is smaller, gross profit is greater. In inflationary times the ending inventory will be greater if we use the FIFO method, since it assumes we counted the more expensive inventory on hand at year-end. If we use LIFO, the reverse is true: By assuming that the “cheap” inventory is still on hand at year-end, cost of goods sold is greater and gross profit is smaller. You can remember this with an easy rule of thumb: In times of rising prices, LIFO understates earnings and FIFO overstates earnings.
Is one method better than another? Even though your intuition tells you that FIFO makes more sense, LIFO may be a better predictor of earnings. As we’ve just seen, LIFO increases cost of goods sold, resulting in lower earnings. It’s a more conservative form of accounting. The assumption is that a business’s cost of goods sold next year will more closely approximate the conservative result LIFO produces.
From your standpoint as the buyer of a business, you should be careful about a business that reports inventory on FIFO. Not only does FIFO pump up the net worth of the business by increasing the values assigned to inventory, it also increases the business’s gross profit by lowering the cost of goods sold.
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