Comparing the accounting implications of valuing inventory under FIFO and LIFO methods of a fast moving consumer goods (FMCG) company during a period of rising prices
Inventory constitutes a large part of a company’s assets. Companies use different accounting methods to report inventory and these methods have different implications on income taxes, profits, and cash flow. The two common methods used by companies include first in, first out (FIFO) and last in, last out (LIFO). This paper attempts to analyze the accounting implications of valuing inventory under FIFO and LIFO of a fast moving consumer goods (FMCg) company during a period of rising prices. Under FIFO, it assumes that the first cost making its way into the inventory is sold first (Accounting for Management, 2012). Conversely, LIFO method assigns the last cost of inventory to goods sold. A fast moving consumer goods company would pay less income tax under the LIFO inventory accounting method during a period of rising prices than under FILO.
A FMCG company using LIFO during a period of rising prices would be selling its inventory at the highest prices. This would result into an increase in the cost of goods sold and lower the net income recorded by the company during that accounting period. This would result into the company paying less tax on the lower net income. Conversely, if an FMCG company decided to use FIFO accounting method in periods of rising prices, the cost of goods sold would be lower resulting into higher net income. This would make the company pay more tax at the end of the accounting period. One third of companies in the US use LIFO because it minimizes income tax payments during periods of increasing prices (Harrison, Horgren, & Thomas, 2010).
Most companies consider LIFO more realistic than FILO in terms of net income value because it expresses the most recent cost of inventory. FIFO uses the oldest cost inventory, which would not provide a realistic measure of inventory expenses during a period of rising prices (Accounting Tools, 2012). In such case, the ending inventory under LIFO would be lower than that of FILO because it accounts for price increase.
Companies planning to lower their income at the end of an accounting period would buy more inventories and use that inventory for cost of goods sold. This will enable a company to pay less tax. The main criticism of LIFO is that it allows companies to manipulate income by timing the purchase of inventory (Harrison, Horgren, & Thomas, 2010). Managers can decide to purchase inventory before the end of the year in order to decrease reported income. On the other hand, managers planning to report higher income can avoid buying inventory before the end of the year.
Many managers find FILO applicable in many business scenarios than LIFO because it provides better accounting. FILO provides a systematic or logical manner of selling goods. This unity in flow of goods provides an efficient control of materials in especially in FMCG companies that deal with perishable goods. One problem with LIFO is that it is not accepted by IFRS and many countries follow IFRS framework (Department of the Treasury, 2012). In addition, LIFO requires maintenance of more records for a longer duration of time, which may prove tiresome for many businesses. LIFO would require a company to use inventory records acquired several years ago.
In conclusion, a FMCG company would opt for LIFO during periods of rising prices to pay less income tax. Using FILO in times of rising prices would result into lower cost of goods sold and higher net income. Thus, the company would have to pay more taxes during that accounting period resulting into more losses.
References:
Accounting for Management. Retrieved November 3, 2012from http://www.accounting4management.com/fifo_method_of_materials_costing.htm
Accounting Tools. Retrieved November 3, 2012 from http://www.accountingtools.com/fifo-vs-lifo-accounting
Harrison Jr, W.T, Horngren, C.T, Thomas, C.W. (2010). Financial Accounting (8th ed) (p9): Upper Saddle River, NJ: Pearson Prentice Hall
Internal Revenue Service. Retrieved November 3, 2012 from Department of the Treasury: http://www.uic.edu/classes/actg/actg516rtr/Notes/06-IRS-FIFO-LIFO.htm
