In Brief
The recent surge in inflation has led managers to reassess the best inventory valuation methods—first-in-first-out (FIFO) or last-in-first-out (LIFO). In times of rising prices, FIFO typically results in higher earnings, while LIFO can reduce tax liabilities. This article explores the advantages and disadvantages of each method, providing accountants with the insights needed to advise managers on whether to switch methods in today’s economic climate. It also presents a detailed example illustrating how LIFO results in a more accurate income statement that better reflects current economic conditions and protects all stakeholders from the impact of inflation, while FIFO does not.
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Recent years have seen the highest levels of inflation in the United States since the early 1980s. This has been blamed on the COVID-19 pandemic, which affected many businesses and supply chains (B. Bernanke and O. Blanchard, “What Caused the U.S. Pandemic-Era Inflation?” Conference Draft, Brookings Institute, May 23, 2023). The pandemic led to stimulus packages and unemployment policies aimed at helping U.S. workers and businesses. In November 2021, inflation for durable goods rose to 14.9%. Fuel prices rose by 49% from January 2022 to June 2022, while higher energy costs caused inflation to rise further in 2022, reaching 9.1%, a high not seen since 1981. In 2023, in an effort to combat inflation, the Federal Reserve increased its benchmark rate four times in a row, yet inflation remained high, outpacing the growth in wages and spending. Businesses that managed to weather the pandemic struggled to maintain positive earnings numbers and to fortify their supply chains. According to the National Bureau of Economic Research, earnings per share forecasts over 2020 earnings were reduced by 16% (A. Landier and D. Thesmar, “Earnings Expectations During the COVID-19 Crisis,” The Review of Asset Pricing Studies, vol. 10, no. 4, 598–617, 2020). Accounting firms and consulting practices attempted to advise firms on appropriate accounting choices in this new economic environment. One of the areas addressed, due to drops in both inventory levels and earnings, was the choice of inventory valuation method. Many are aware of the relevance of the measurement of inventory to profitability. The lower the capital account (inventory), the higher the operational expenses (cost-of-goods-sold). This inverse relation affects profitability and can be manipulated for financial and tax purposes. The manipulation of inventory values played a role in well-known accounting frauds. These include inventory frauds perpetrated by McKesson in the 1930s, Allied Oil in the ‘60s, Crazy Eddie in the ‘80s, and Phar-Mor in the 1990s (Justin Mock, “Classic Case Studies in Accounting Fraud,” Miami University, OhioLINK Electronic Theses and Dissertations Center, 2004, https://tinyurl.com/2zp2hhff).
More recently, research has found that 19% of fraud cases in the Audit Analytics database from 2000 to 2014 were related to the inappropriate determination of inventory costs, cost of sales, and inventory balances at the year-end (Fatima Alali and Sophia I-Ling Wang, “Characteristics of Financial Restatements and Frauds: An Analysis of Corporate Reporting Quality from 2000–2014,” The CPA Journal, Nov 2017, vol. 87, no. 11).
When valuing inventory, companies have traditionally selected from a range of acceptable accounting methods, including first-in-first-out (FIFO) and last-in-first-out (LIFO), among other reasonable approaches. Each method reflects a different assumption about the flow of inventory and can significantly impact financial reporting outcomes. The primary benefit of FIFO has always been higher earnings. In periods of rising prices, older inventory (first in) is expensed first, thus contributing to a lower cost of goods sold (COGS) and, in turn, a higher pretax income. LIFO, on the other hand, delivers higher COGS numbers, due to charging the highest-priced inventory to cost of goods sold, thereby lowering pre-tax income, and lowering the tax liability. And that benefit grows as inventory pricing rises due to inflation or other factors, and as tax rates increase. Therefore, all else being equal, management at times must choose between reporting higher earnings–and paying the taxes on them—or reporting less attractive earnings numbers while achieving a tax benefit.
PricewaterhouseCoopers (“Taxpayers Should Consider Immediate Action to Adopt the LIFO Inventory Method to Expense High Inflation,” Feb. 1, 2022, https://tinyurl.com/2b5wc4up), amongst other business consulting firms (Kreischer Miller Team, “Should Your Company Consider Adopting LIFO as a Response to Inflation?” Feb. 9, 2022, https://tinyurl.com/ytut74rm), advised companies to consider switching to the LIFO inventory method to help mitigate the effects of inflation by reducing the company’s tax burden and increasing cash flows available for reinvestment. But is that temporary advice to take on an opportunistic approach, or is it a fix for an ongoing problem? The Tax Foundation, in an October 2022 article, predicted that LIFO may become the preferred choice for more businesses due to high inflation rates (A. Muresianu and A. Durante, “Understanding the Tax Treatment of Inventory: The Role of LIFO,” The Tax Foundation, Fiscal Fact 801, Oct. 12, 2022, https://tinyurl.com/2c8hjtzm). However, surprisingly, rather than heed accountants’ and consultants’ advice to switch to LIFO, businesses actually chose to switch from LIFO to FIFO or to other methods.
In 2021 and 2022, about 30 U.S. companies switched their inventory accounting method to FIFO from LIFO, up from 13 companies in 2019 and 2020 combined, according to investment research firm Bedrock AI, (Mark Maurer, “Inflation Has More U.S. Companies Ditching ‘Last-In, First-Out’ Accounting,” The Wall Street Journal, March 23, 2023, https://tinyurl.com/yp8n5c49). Overall, an estimated 55% of companies in the S&P 500 used FIFO as their primary inventory method and 15% used LIFO, according to Credit Suisse Group AG. Testimony before the Senate Committee on Finance by Professor George Plesko of the University of Connecticut affirmed that the use of LIFO has declined steadily since the early 1980s from approximately 70% of large firms to about 40% in 2004 (J. Kostolansky, “The Impact of LIFO in the Fortune 500 in 2007,” The Journal of Applied Business Research, September/October 2009). Yet, today, only about 7% of U.S. public companies with inventory use LIFO, with usage skewed toward larger companies. “When inflation started, a lot of the accounting firms suggested companies could save on taxes by switching to LIFO, but that hasn’t been borne out in the data,” Bill Mayew, a professor at Duke University, noted (S. I. Weiss, “More Firms Drop LIFO Amid Inflation, Low Taxes,” CFO Brew, May 4, 2023, https://tinyurl.com/464phx8x).
Why Keep Using (or Switch to) FIFO?
There are no costs in switching from LIFO to FIFO for entities that are already run on a FIFO basis internally. The primary reason companies are switching, however, is to be able to continue to show high earnings numbers to investors. In essence, LIFO is a key to what may be seen as “over capitalization” of an operating expense, which can be viewed by some as manipulative. According to Mayew, “The increase in companies switching to FIFO accounting may indicate that the pressure to present competitive earnings figures is outweighing the tax benefits afforded by LIFO” (S. I. Weiss, “More Firms Drop LIFO Amid Inflation, Low Taxes,” CFO Brew, May 4, 2023). Kris Bennati, Bedrock AI’s CEO, confirmed this statement by saying, “in a highly inflationary environment, FIFO accounting delays the impact of rising prices on net income, while LIFO accounting has a much more punishing impact on earnings.” Paccar Controller Michael Barkley echoed these sentiments in comments to the Wall Street Journal: “When inflation popped up, we said we’re taking hits to our margin that make us noncomparable. And for what?” (Maurer 2023).
In Favor of LIFO
A taxing authority could theoretically answer the question: should companies stop using LIFO? Without LIFO, the U.S. Treasury would expect to see higher taxes being paid by companies to the tune of billions of dollars. In fact, repealing LIFO has two separate revenue effects. LIFO repeal would raise about $1 billion annually by reducing the COGS deduction alone. In addition, when a company elects to value inventory using LIFO, it must also report LIFO reserves which reflect the difference between inventory valued by the LIFO and FIFO methods. Companies that switch from LIFO to FIFO must take the value of LIFO reserves into income over five years, substantially raising their annual income, and thereby their tax bills. The Congressional Budget Office, in 2020, estimated that taxes raised from LIFO reserves would approximate $50 billion over four years. With higher inflation and higher oil prices affecting new inventory costs, the LIFO reserve would be greater, especially from large corporations in the energy sector, and repeal could raise substantially more tax revenue (Matheson and Brosy, “Inflation and Oil Price Spikes Revive Case for LIFO Repeal,” Tax Policy Center, May 12, 2022, https://tinyurl.com/2eb9urpp).
Numerous large companies who use LIFO have resisted the elimination—and the substantial tax penalties—which would arise from a change to a different inventory valuation method (see e.g., Q.Ling and D.P.. Tinkelman, “Costs and Benefits of the LIFO-FIFO Choice,” Journal of Corporate Accounting & Finance, 2020). Companies like Caterpillar, Sherwin-Williams, Amazon, Macy’s, Kroger, and Home Depot have been using LIFO for decades for their U.S. operations and are in no rush to consider a change.
The Save LIFO Coalition, formed in 2006, has consistently fought to keep LIFO in the tax code. They argue that repealing LIFO would disincentivize inventory investment, hampering efforts to make U.S. supply chains more resilient. It would also reduce economic growth and penalize industries that typically keep more inventory on hand, such as retailers of durable goods (Muresianu and Durante 2022). Companies that deal in nonperishable commodities, like petroleum (D.P. Tinkelman and C. Tan, “Estimating the Potential Revenue Impact of Taxing LIFO Reserves in the Current Low Commodity Price Environment,” Journal of the American Taxation Association vol. 40, no. 2, 2018), metals, and chemicals also use LIFO accounting when allowed, but are often portrayed as examples of corporate behemoths rather than local businesses—making the Save LIFO lobbyists’ case tougher to promote.
It should be noted that a contributing factor to the trend away from LIFO is that IFRS disallowed its use in 2003. Companies who may prefer to use LIFO but also prepare international financial statements have had to prepare two sets of statements. While several companies, like Walmart, have chosen to prepare LIFO statements for its U.S. segments and FIFO for the rest of its operations overseas, most companies, like Lowe’s and Coca-Cola, find using dual inventory methods too burdensome and choose FIFO.
Until the late 1980s, when LIFO seems to have fallen out of favor, it was considered by many to be the most accurate income measure during inflationary periods (S. C. Lessard, “Giving Life to LIFO: Adoption of the LIFO Method of Inventory Valuation by the Income Tax Code,” Tax Law, vol. 60, no. 78, 2006). Lessard (2006) cites Frederic Hichman, assistant secretary of the treasury for tax policy, as saying that not using the LIFO method of inventory valuation could misrepresent income. Even in noninflationary periods, LIFO was looked at largely as a way of smoothing income and taxes. However, there was still the “LIFO puzzle,” coined to describe the mystery as to why many companies paid millions of dollars in extra taxes by staying with FIFO [G. Biddle, “Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory Policy,” Journal of Accounting Research, (Supplement 1980) p. 235-280,1980]. Research has shown that it’s not investors, but rather managers, who prefer using FIFO in order to receive higher compensation, which may be based on income measures (F. A. Gul, “Free Cash Flow, Debt-Monitoring and Managers’ LIFO/FIFO Policy Choice,” Journal of Corporate Finance, vol. 7, no. 4, p. 475-492, 2001). In fact, Jensen (M.C. Jensen, “Eclipse of the Public Corporation,” Harvard Business Review p. 61–74, September/October 1989) and Maloney et al. (M. T. Maloney, R. E. McCormick, and M. L. Mitchell, “Managerial Decision Making and Capital Structure,” Journal of Business, p. 189-217, 1993) find that at higher levels of debt, when managers may be under more scrutiny, they are incentivized to make decisions more consistent with the interest of shareholders and are more likely to choose LIFO—minimizing taxes and increasing shareholder wealth.
This article presents an example highlighting the inventory purchase, sale, and subsequent allocation of funds to demonstrate how LIFO minimizes taxes and maximizes shareholder wealth in periods of rising prices, which has been assumed to be the case since the mid 1970s (H.Z. Davis, “History of LIFO,” The Accounting Historians Journal, vol. 9, no. 1, Spring 1982). It illustrates how using LIFO not only results in the most equitable outcome to all stakeholders, it also contributes to the ongoing sustainability of the business. Furthermore, it demonstrates how, while companies using FIFO may present higher earnings numbers, once adjusted for inventory replacement cost, economic earnings are lower than they would be under LIFO.
LIFO-FIFO Demonstration Model
Inventory cost flow assumptions.
The total cost of goods acquired by a company in a given period for inventory plus the cost of any inventory remaining from the previous period is known as Cost of Goods Available for Sale (COGAS). This total cost is eventually divided on a company’s financial statements (Exhibit 1) between:
- ▪ The cost of inventory that is sold, Cost of Goods Sold (COGS), an expense on a company’s income statement; and
- ▪ The cost of unsold inventory, reported as Inventory (INV) in the current assets section of the balance sheet.
EXHIBIT 1
Cost of Goods Available for Sale
Because the sum of these two values, COGS and INV, equals COGAS, the greater the costs assigned to COGS, the lower the costs remaining in INV, and vice versa. The implications of this seemingly simple observation go to the crux of the LIFO issue and are illustrated by the following example.
Example.
An entity has two units of goods available to sell. The first unit was purchased earlier for $100; the second was purchased more recently at the current cost of $110. If both units remain unsold, the balance reported in Inventory (INV) would be $210 (100 + 110). Now assume that one unit is sold at a price of $132, consistent with a 20% markup of the current $110 cost. Under the LIFO method, the entity would report COGS of $110 (the latest cost) and an INV balance of $100. The COGS of $110 would result in $22 of pre-tax income. On the other hand, under the FIFO method, the entity would report COGS of $100 (the older costs) and an INV balance of $110. The lower COGS of $100 would result in higher pre-tax income of $32.
The economic perspective.
The key point from a theoretical economic perspective is that the cost of an item is its replacement cost. Consider the price one would charge a friend who wanted one of the available units under the assumption of not making a profit or taking a loss. One would charge a friend the cost one would incur to replace the unit. Thus, the “economic” cost of both units in this example is $110. Under the historical cost model, only the balance sheet or income statement can reflect this $110, but not both. As illustrated by Exhibit 2, an accountant faces a trade-off as to where to place the more recent (higher) current costs. Under FIFO, the balance sheet reflects inventory at the current cost of $110. Under LIFO, the income statement does. Conversely, FIFO uses older costs in income, and LIFO does so for the balance sheet.
EXHIBIT 2
The Trade-Off Cost Increases
It should be noted that the LIFO method is more consistent with the conservatism principle of accounting than FIFO. As shown in this example, the LIFO method results in lower reported income than FIFO, consistent with conservatism. In addition, LIFO results in a lower reported inventory balance and lower reported net assets on the year-end balance sheet, again consistent with conservatism. In an environment of rising costs, using FIFO would result in a higher value of (net) assets relative to LIFO.
Tax policy.
The crux of this analysis are the implications of the tax policy choice of LIFO versus FIFO. Returning to the example and assuming a 30% tax rate, the respective methods would result in the following taxes payable:
The increased tax burden under FIFO would be $3 (30% × $10), or a 45% increase over what the tax would have been under LIFO ($3 ÷ $6.6).
Consequences of FIFO.
Consider how the FIFO inventory cost flow method can impact businesses. Returning to this example, assume first that there had been no change in costs and the second unit also cost $100. There would be no difference between the LIFO and FIFO methods, as both would report COGS of $100 (and INV of $100). In this case, the policy of setting the sales price at a 20% markup of current cost would result in a sales price of $120. Thus, under both FIFO and LIFO, pre-tax income would be $20, and at the 30% tax rate, the company would pay $6 in taxes. The company would retain an after-tax profit of $14.
In this scenario, the $120 generated in sales is allocated as follows: $6 to taxes, $14 to retained earnings (which may be paid out to investors as dividends), and the remaining $100 can be used to purchase the next unit of inventory to replace the unit that was sold (see Exhibit 3). In this way, the company can continue operating as a going concern.
EXHIBIT 3
The Impact of a 10% Cost Increase
Now consider what happens when costs increased to $110 per unit. Under LIFO, COGS would be $110, resulting in pre-tax income of $22. At a 30% tax rate, the company would pay $6.60 in taxes and be left with $15.40 in earnings. The $132 of sales revenue is allocated as follows: $6.60 to taxes, $15.40 to retained earnings, and the remaining $110 can be used to purchase the next unit of inventory.
Note that all the numbers in this scenario are equal to 110% of what they were before the 10% price change. The LIFO inventory method results in all stakeholders having their share adjusted by the same amount—the change in price. If, however, an entity was forced to use FIFO, COGS would be $100, and pre-tax income would be $32. At the 30% tax rate, the tax bill would be $9.60 with after-tax earnings of $22.40. But the company would still need to replace the unit of inventory that was sold.
Exhibit 3 illustrates the dilemma. After allocating $9.60 of the $132.00 in sales revenue to taxes, $122.40 is left. Leaving the reported after-tax profit of $22.40 in retained earnings (to be paid as dividends) would not enable a business to replace the inventory with the remaining $100.00. On the other hand, using $110.00 on the replacement unit would leave the company with only $12.40 in earnings, an 11% drop in earnings (of $14.00) from before the price change. Similarly, if a business insisted on maintaining its level of profits adjusted for the price change (to $15.40), it would not be able to stay in business because it wouldn’t have enough funds to replace inventory. It would be short $3 because it would only have $107 (132.00 – 9.60 – 15.40) rather than the $110 needed. (This $3, of course, is the additional tax paid under FIFO.) When examined in this light, it seems that the FIFO inventory method often presents business owners with a difficult choice. They must either insist on maintaining their profitability/return on investment and possibly be forced to eventually shutter their business (since they will have difficulty replacing their inventory), or stay in business but accept a lower return. In short, under FIFO, a company is not protected against rising costs. There is seemingly only one entity that is protected by FIFO – the taxing authority. The tax revenues of $9.60 are 160% of the $6.00 that would have been received before the 10% price increase.
Because the most recent cost is more reflective of current economic conditions, LIFO results in an income statement that is more reflective of current economic conditions than FIFO. Corporate taxes are imposed on income, and one could argue that taxes should be based on income that most reflects an entity’s current economic reality. To that end, calculating taxes using a LIFO income statement may more accurately reflect income. Furthermore, doing so would not skew the allocation of profits resulting from input cost increases in favor of tax authorities and at the expense of business owners who may have to choose between accepting lower returns or curtailing operations.
Limitations
The discussion above describes how, in periods of rising prices, LIFO delivers the most equitable division of wealth and is most beneficial to a company’s long-term profitability. But there are also several reasons why a switch to LIFO is not as attractive a proposition as it might have been years ago. First, since the Tax Cuts and Jobs Act of 2017 lowered the corporate tax rate from 35% to 21%, the tax benefit of switching to LIFO has substantially decreased. Second, companies have become more adept at inventory management, and just-in-time inventory has helped decrease the amount of time between purchasing and selling, so LIFO and FIFO inventory valuation is not as different as it may have been in the past. Third, while inflation has been high since 2021, many believe this is a temporary phenomenon (D.P. Tinkelman, and Q. Ling, “The Rise and Decline of LIFO,” Accounting Historians Journal, vol. 49, no. 2, p.103–120, 2022). Fourth, as mentioned earlier, IFRS’s disallowance of LIFO has caused many large companies to disregard it. Finally, with management compensation regularly based on income measures, high income will remain a priority for managers.
As in any model, the scenario presented above relies on several assumptions that may not always be present. We believe, however, that the assumptions underlying the model represent a likely scenario in many industries. First, the model assumes that sales prices are marked up at a specified percentage above cost, which may not always be the case. Second, the model primarily deals with an inflationary period in which prices and costs are expected to rise. While this is a very typical scenario in many industries, it is not necessarily expected to occur in every industry and in every time period. Finally, the model makes an implicit assumption that inventory is always replenished at a constant rate. In theory, if a company reduces its inventory levels and continues to sell out older inventory before making new purchases, the effect of the chosen inventory costing method on the company’s income statement may differ.
