LIFO vs. FIFO: The Accounting Systems That Impact Your Stock Choices

Feb 1, 2022 01:49 PM ET
LIFO vs. FIFO: The Accounting Systems That Impact Your Stock Choices

Stock trading is often an act of balance. Companies want to show investors that they have a lot of potential and little risk. However, they need to deliver on their promises to keep the investors. In order to attract investors, companies will often show that they have higher profits, higher assets, and lower liabilities. They can legally achieve these goals by pursuing different accounting systems. In this article, we will introduce LIFO and FIFO, the accounting systems that can impact your stock choices.

What is LIFO

LIFO, also known as Last In First Out, is an accounting system that records the cost of the goods sold to be the last unit that came in. This leaves older inventory that is valued less in the inventory section of the balance sheet. 

What is FIFO

FIFO, also known as First In First Out, is an accounting system that records the cost of the goods sold to be the first unit that came in. This leaves newer inventory that is worth more in the inventory section of the balance sheet. 

Working examples

Given a company that sells winter boots stocked up their inventory at two separate times. The first time they bought 200 boots for $20 each, whereas the second batch of 200 boots cost $30 each. For all examples, we will assume that the company sold 150 out of their 400 boots. 

*Disclaimer: Prices of inventory items are increasing because there is an assumption that we are in an expansionary market condition, where there is inflation. All results and analysis are reversed when there is deflationary pressure. 

FIFO vs. LIFO - Inventory

Inventory in accounting is considered an asset. A company with high assets is appealing to investors because it is deemed safer. Worst case scenario, assets can be liquidated to repay stockholders. Therefore, stockholders will generally look for companies with high assets. 

If the company employs the FIFO system, they would sell 150 units of their $20 boots and have 50 units, $20 boots, and 200 units of $30 boots. This means the total value of their remaining inventory is: (50 x $20) + (200 x $30) = $7000. 

If the company employs the LIFO system, they would sell 150 units of their $30 boots and have 50 units, $30 boots, and 200 units of $20 boots. This means the total value of their remaining inventory is: (50 x $30) + (200 x $20) = $5500. 

The LIFO system will yield lower assets compared to the FIFO system. If the company wants to optimize assets, it will be using a FIFO system.  

FIFO vs. LIFO - Cost Of Goods Sold

The basic formula to calculate profit is: Profit = Total Revenue - Total Cost. Cost of Goods Sold (COGS) is one part that constitutes ‘Total Cost’. Investors would be looking for companies with higher profit as they can reinvest in their company to make it better through retained earnings or share out to shareholders as dividends. 

If the company employs the FIFO system, they will sell 150 units of their $20 boots. This means the total value of their COGS is: (150 x $20) = $3000. 

If the company employs the LIFO system, they will sell 150 units of their $30 boots. This means the total value of their COGS is: (150 x $30) = $4500. 

In this case, the LIFO system has a higher cost of goods sold which lowers the profitability of the company compared to the FIFO system. However, this is where the main dilemmas of most companies come in: profit optimization or tax limitation?

FIFO vs. LIFO - Taxation

Companies are taxed based on their income. The LIFO system will give them lower profitability which means they will be taxed less than if they employed the FIFO system. 

So what does this mean?

If a company posts really high income and high inventory, you should double-check their accounting system as they could be using the FIFO system. This means the company has higher tax liabilities that it might need to fulfill. This will take away from your dividends (if the company declares dividends) and take away from their retained earnings which they can be reinvesting into the company

The FIFO system is usually a tactic used by some businesses to ‘woo’ and impress investors. 

On the other hand, a company that employs the LIFO system might not seem to be as impressive. They will have higher COGS and lower inventory. In return, the company will have a lower tax liability. 

A company’s accounting system could also reveal details about their products' pricing. FIFO is more advantageous for firms that have steady product prices. This reduces the tax liability from FIFO whilst also benefiting from boasting their higher assets. LIFO is usually used by firms with rising product prices or during a time of high inflation. 

Summary

The chart below summarizes the effects Last In First Out (LIFO) and First In First Out (FIFO) have on the cost of goods sold, profits, assets, and tax liabilities. 

FIFO

LIFO

Lowered COGS

Increased COGS

Increased Profits

Reduced Profits

Higher Assets

Lowered Assets

Higher Tax Liabilities

Lower Tax Liabilities

FIFO are normally used for companies with relatively stable product prices. Companies that want to obtain more investments from prospective shareholders will also use this method to impress them. However, LIFO is the main accounting system used by most firms as it is more tax efficient. 

When evaluating a stock price, make sure you also analyze the information available about the company thoroughly. It could be over-hyped or under-hyped due to the fact that many people are looking at surface data such as assets and profits without dissecting how those numbers are calculated. Taking this extra step will help you make better decisions on the stock market!

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