Financial Reporting

Question: In periods of inflation, FIFO reports a higher gross

profit (and, hence, net income) and a higher inventory balance than does LIFO. Averaging presents figures

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that normally fall between these two extremes. Such results are widely expected by those readers of financial

statements who understand the impact of the various cost flow assumptions.

Any one of these methods is permitted for financial reporting. Why is FIFO not the obvious choice for every

organization that anticipates inflation in its inventory costs? Officials must prefer to report figures that make the

company look stronger and more profitable. With every rise in prices, FIFO shows a higher income because the

earlier (cheaper) costs are transferred to cost of goods sold. Likewise, FIFO reports a higher total inventory on

the balance sheet because the later (higher) cost figures are retained in the inventory T-account. The company is

no different physically by this decision but FIFO makes it look better. Why does any company voluntarily choose

LIFO, an approach that reduces reported income and total assets when prices rise?

Answer: LIFO might well have faded into oblivion because of its negative impact on key reported figures (during

inflationary periods) except for a U.S. income tax requirement known as the LIFO conformity rule. Although this

tax regulation is not part of U.S. GAAP and looks rather innocuous, it has a huge impact on the way inventory

and cost of goods sold are reported to decision makers in this country.

As prices rise, companies prefer to apply LIFO for tax purposes because this assumption reduces reported income

and, hence, required cash payments to the government. In the United States, LIFO has come to be universally

equated with the saving of tax dollars. When LIFO was first proposed as a tax method in the 1930s, the United

States Treasury Department appointed a panel of three experts to consider its validity. The members of this group

were split over a final resolution. They eventually agreed to recommend that LIFO be allowed for income tax

purposes but only if the company was also willing to use LIFO for financial reporting. At that point, tax rules bled

over into U.S. GAAP.