Many accounting rules are highly prescriptive. However, in the case of inventory, companies have the freedom to choose between two accounting methods: first-in-first-out, or FIFO, and last-in-first-out, or LIFO. The decision can have a significant impact on a company's reported earnings. While most companies stick with FIFO or LIFO for consistency, sometimes the owners change their minds. When they do, companies must comply with special reporting requirements to keep their investors informed.
FIFO and LIFO represent accounting methods that determine the value of a company's unsold inventory, cost of goods sold and other transactions. Under FIFO, companies attribute the cost of their oldest goods to their newest sales. The opposite is true under LIFO: The cost of the newest goods is attributed to the newest sales. In periods of rising prices, or inflation, FIFO offers the lowest cost of goods sold and the highest reported profits. In periods of falling prices, or deflation, LIFO results in the highest reported profits.
Suppose that a company has three finished widgets sitting in its warehouse. The first widget cost $100 to produce, the second $150 and the third $200. Assume that the widgets were produced on Jan. 1, 2 and 3, respectively. Now, the company receives an order for one product at a retail price of $300. Under LIFO, the company would record a profit of $100 ($300 price minus $200 cost of goods sold). Under FIFO, the profit would be even greater: $200 ($300 price minus $100 cost of goods sold).
Most companies switching from LIFO to FIFO choose to restate their historical financial statements as if the new method had been used all along. It's important that companies keep precise records to make these changes. The income statement is affected from changes in cost of goods sold, and this affects all measures of earnings, such as operating income and net income. The balance sheet is also affected from changes in inventory valuations. All of these changes trickle down to impact the cash flow statement.
When companies haven't kept accurate records or it's impractical to do so, they may instead only adopt the new accounting method going forward. The first year using the new accounting method becomes the base year for all future FIFO or LIFO calculations. The company must provide footnotes to explain why it was impractical to restate its historical financial statements. Generally speaking, records are usually easier to obtain when switching from LIFO to FIFO than the other way around.
The Securities and Exchange Commission requires public companies to submit financial reports that follow generally accepted accounting principles, including preparing standardized financial statements and explaining changes in accounting methods. Private companies often follow GAAP reporting, though they're not obligated to, because investors and lenders are trained to evaluate GAAP information and demand it from companies. If a private company is making the switch from LIFO to FIFO, its owners will probably want to explain it to stakeholders.