Under generally accepted accounting principles (GAAP), companies are free to choose among three ways to report cost flow assumptions for inventory. They can use the first-in, first-out (FIFO) method, the last-in, first-out method (LIFO), or they can calculate inventory costs by using the average cost method. By comparison, companies reporting under International Financial Reporting Standards (IFRS) are required to use FIFO only.
LIFO has been the subject of some budget controversy in the United States. In 2014, the administration of President Barack Obama sought to ban LIFO, which it said allowed companies to make their incomes appear smaller for the purposes of taxation. Proponents for keeping LIFO say repeal would increase the cost of capital for companies and have negative consequences for economic growth.
Other arguments for moving away from LIFO include bringing U.S. companies closer to IFRS reporting standards. In 2010, the Securities and Exchange Commission (SEC) started efforts to converge GAAP and IFRS. A main impediment to that happening was the issue of LIFO.
LIFO vs. FIFO
Consider a company that makes toy cars. Input costs are not fixed over time. The first 100 toy cars might cost $10 to make, while the last 100 units might cost $12.
Under FIFO, the first unit of inventory is recognized as the first sold off the shelves. So under FIFO, the cost of goods sold (COGS) for the first sales is $10. Under LIFO, the first sales are assigned a $12 COGS. That $2 difference would significantly impact the company's financial statements and tax filing. Choosing FIFO would have the impact of making its profit appear larger for investors. Conversely, choosing LIFO would have the impact of making its profit appear smaller to the tax authorities.
Under GAAP, companies have a choice as to which inventory valuation system is the most advantageous for reporting purposes. This is not the case with the IFRS method, where all companies are locked into FIFO.