Explain FIFO and LIFO. In a period of rising prices, which method produces higher reported net income, and why?
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The answer
In a period of rising prices, FIFO produces higher reported net income than LIFO. FIFO, or first-in, first-out, assumes the oldest inventory costs are expensed to cost of goods sold first, while LIFO, last-in, first-out, expenses the most recent costs first. Because input costs are rising, older units were purchased at lower prices.
Under FIFO, those cheaper costs hit COGS, so COGS is lower, gross profit is higher, and net income is higher. Under LIFO, the newer, more expensive units flow to COGS, which raises COGS and depresses net income. That is the accounting effect: FIFO assigns old, low costs to the income statement, leaving ending inventory valued near current replacement cost.
LIFO does the opposite, matching current high costs with revenue and leaving inventory at stale lower values. While LIFO reduces reported net income in an inflationary environment, it also reduces the current tax bill, which is the real cash reason some U.S. companies choose it despite showing lower earnings.
Income statement
| Revenue | 1,000 |
| COGS | (600) |
| Gross profit | 400 |
| SG&A | (180) |
| EBITDA | 220 |
| D&A | (40) |
| EBIT | 180 |
| Interest expense | (20) |
| Pre-tax income | 160 |
| Taxes | (40) |
| Net income | 120 |
Also asked as
- Define COGS and gross margin. What does gross margin tell you about a business that operating margin does not?
- State the inventory roll-forward identity and explain how it's used to solve for COGS.
- Why would a company ever choose LIFO if it results in lower reported net income?
- Does IFRS permit LIFO? What must a US company using LIFO disclose to allow comparison with FIFO or IFRS peers?
- What is a LIFO liquidation, and why does it produce a misleading, one-time boost to gross margin?
- Explain the lower-of-cost-or-net-realizable-value principle and whether an inventory write-down is a cash or non-cash charge.
- A company has beginning inventory of 500 units at $8/unit and purchases 800 units at $9.50/unit during the year. It sells 1,000 units. Calculate COGS and ending inventory under both FIFO and LIFO.
- A company's LIFO inventory is $180M with a LIFO reserve of $30M at the start of the year, growing to $42M by year-end. LIFO COGS for the year is $700M. Calculate FIFO-equivalent ending inventory and FIFO-equivalent COGS.
- A LIFO company's gross margin rises from 32% to 41% year over year with flat input prices, while its LIFO reserve falls from $90M to $55M and inventory unit volume drops sharply. Explain what likely happened, and describe how you would adjust reported COGS to normalize the margin for a valuation model.
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The rest of this topic
Depreciation, write-downs and the tax shield