Tuesday, May 19, 2009

LIFO and FIFO: Fundamentals of Accounting

The CFA curriculum focuses on LIFO versus FIFO accounting in some of their questions and I just wanted to review the reasons for some of the relationships and differences between these two accounting methods by looking at the underlying accounting principles.

First some basics. Why would you choose one method over another? LIFO provides a more accurate picture of profitability, especially if prices are increasing rapidly and / or you have high asset turnover. It paints a more realistic picture regarding your margins. However, from an accounting perspective, FIFO makes sense because it matches the revenue earned with the products created.

Often, questions are based in scenarios of rising prices (as this is usually the case due to inflation). If questions are framed in a scenario with declining prices, the relative relationships are reversed. Let's look at two graphs, both with increasing prices and each using a different accounting method (LIFO versus FIFO):
This is a neat visual aid for understanding the relationships between the two accounting methods during rising prices. In LIFO, the most recently produced units are sold first, therefore the COGS is the area under the right side of the graph whereas the Inventory is the area under the left side. This is reversed in FIFO, where the COGS is on the left and Inventory is on the right. Also notice that in a time of rising prices, COGS will be higher in LIFO (selling the expensive stuff first) versus FIFO (selling the previously made cheaper stuff first).

In an unusual scenario of declining prices, you can use the same tool to understand the relationships:

In this case, the relationships are reversed. With declining prices, FIFO has smaller inventory and higher COGS while LIFO has larger inventory and smaller COGS.

In LIFO accounting the last products created are the first ones to be sold (Last In First Out). To understand what happens in a scenario with rising prices we'll take a step by step look at what happens at each stage of the financial statement:
  1. the most expensive products are sold first (therefore COGS goes up relative to FIFO)
  2. there is less profit (EBITDA, EBIT, EBT, EAT are all lower)
  3. there is less tax is payed
  4. net income (retained earnings) is lower
  5. the ending inventory is lower relative to FIFO (you sold the "expensive" products and kept the "cheaper" products in inventory)
  6. implies lower working capital
  7. with the same amount of cash coming in but lower taxes paid the result on cash flow is actually higher in LIFO than FIFO (deferring taxes paid by "keeping profits" in inventory).
Again notice that in a scenario of declining prices, the relationships are reversed.

Note that switching from one accounting method to another produces side effects which can potentially allow management to mislead unsuspecting analysts. The argument for using LIFO, especially in scenarios with rising prices (like oil) is that it can provide a more realistic picture of future profitability. However, once using LIFO, liquidating the LIFO reserve will allow management to report artificially high profits (one time selling of assets usually resulting from reduced production - "selling the cheap stuff"). Each accounting method has its pitfalls for those who are not vigilant.


Shwet said...

but I think LIFO is more misleading than FIFO..as it is also done to inflate ur profits for shareholders and management commission also depends on it..

Joshua Wong said...

Wel... I wouldn't say "misleading". You've always got to pay attention to these sorts things as an analyst.

And LIFO can sometimes paint a more accurate picture if prices rise consistently, because they show the most recent, "last in" COGS.

Each has it's benefits and problems, and I think you've just got to be aware of them. There is a case to be made for each type of system, but at the end of the day, you have to remember that they are just "systems to produce numbers". It's always the story behind the numbers which is more important.