Accounting Standards

FIFO, LIFO, Inventory Reserves and Inventory Diligence

Inventory costing methods determine how purchase costs flow into cost of goods sold. FIFO assigns the oldest costs to COGS, LIFO the newest, and weighted average a blended cost. In rising cost periods, LIFO lowers reported profit and taxes. Reserves for obsolete and slow-moving stock reduce inventory to recoverable value. Diligence tests existence, costing, reserves and liquidation value.

How do FIFO, LIFO and weighted average costing differ?

When identical items are purchased at different costs, a business must choose how to assign costs to items sold and items remaining. First-in, first-out (FIFO) assumes the oldest units are sold first, so cost of goods sold reflects older costs and ending inventory reflects recent costs. Last-in, first-out (LIFO) assumes the newest units are sold first, so cost of goods sold reflects recent costs and ending inventory reflects older ones. Weighted average assigns the average cost of all units available during the period to both.

The physical flow of goods does not need to match the cost flow assumption. A grocer selling perishable goods might use LIFO for accounting even though the oldest stock physically leaves first. LIFO is permitted under US GAAP but not under IFRS. When costs are stable, the methods produce similar results. When costs move significantly, they diverge, affecting gross margin, inventory value, taxable income and every ratio that uses those figures, including inventory turnover, working capital and borrowing base availability.

How does the costing method affect earnings and taxes?

In a period of rising costs, LIFO charges the newest, higher costs to cost of goods sold, which lowers gross profit and taxable income relative to FIFO. That tax deferral is the main reason companies adopt LIFO in the United States, and tax rules generally require a company using LIFO for taxes to also use it in its financial statements. FIFO reports higher profit and a higher inventory balance in rising cost periods, with ending inventory closer to current replacement cost. Disclosures in the inventory note identify the method used for each category of stock, and some companies use different methods for different product lines.

Companies using LIFO disclose a LIFO reserve, the difference between inventory measured on FIFO or current cost and the LIFO carrying amount. Analysts use it to convert to FIFO: add the reserve to inventory, and add the change in the reserve during the period to pre-tax income to restate cost of goods sold. A LIFO liquidation, which occurs when inventory quantities fall and older, cheaper layers are charged to cost of goods sold, can temporarily inflate margins and should be removed when normalizing earnings.

How do inventory reserves work?

Inventory must be written down when its value falls below cost. Under US GAAP, inventory measured on FIFO or weighted average is carried at the lower of cost and net realizable value, while LIFO and retail method inventory follow a lower of cost or market test. IFRS uses lower of cost and net realizable value for all inventory. Write-downs are typically recorded through a reserve for obsolete, slow-moving, damaged or excess stock, with the expense flowing through cost of goods sold.

Reserves involve judgment and are a common area for earnings management. A business can boost margins by under-reserving or by releasing reserves without selling the related inventory. Reserve policies should be based on aging, turnover by SKU, historical write-offs and expected selling prices. Under US GAAP, written-down inventory generally establishes a new cost basis and is not written back up, while IFRS allows reversal when net realizable value recovers. Underwriters should compare reserve levels with actual write-offs and with the aging profile over several periods.

• Aging: share of inventory without movement over 90, 180 and 365 days
• Turnover by SKU: identifies excess quantities relative to demand
• Write-off history: tests whether reserves are adequate
• Margins on recent sales of aged items: tests net realizable value

What should inventory diligence include?

Start with existence. Observe or review a recent physical count and reconcile the count to the perpetual records and the general ledger. Large book-to-physical adjustments at year end indicate weak controls. Then test costing: trace a sample of items to supplier invoices and review how freight, duties and overhead are capitalized. Overhead absorption deserves particular attention in manufacturers, because producing more units than sold capitalizes fixed costs into inventory and temporarily raises margins. Cutoff testing around period end confirms that receipts and shipments are recorded in the right period.

Next, examine reserves and aging as described above, and review the returns and credit history after period end. Look at inventory held at third-party locations, on consignment, or in transit, and confirm ownership and the risk of loss. Finally, compare inventory growth with sales growth. Inventory that grows faster than revenue for several periods may reflect poor purchasing, obsolete product or capitalized costs, any of which can lead to future write-downs and reduced cash flow, with direct consequences for borrowing base availability and margins.

How do lenders value inventory as collateral?

Asset-based lenders lend against the net orderly liquidation value of eligible inventory rather than its book cost. Appraisers estimate what the inventory would bring in an orderly sale over a defined period, net of liquidation costs, and lenders apply an advance rate to that value. Raw materials, work in process and finished goods have very different recovery values. Work in process often has little value outside the business, and specialized components may be worth far less than their cost. Seasonal businesses may also see recovery values vary through the year.

Eligibility criteria exclude items such as slow-moving or obsolete stock, consigned goods, inventory at unapproved locations, and goods subject to supplier liens or retention of title. Periodic field exams and appraisals update these values. The costing method matters here too: LIFO inventory may be carried well below current value, while FIFO inventory may include capitalized overhead that a liquidator would not recover. Lenders should base availability on appraised recovery values rather than on any accounting measure of cost. Concentrations in a few product lines or suppliers can also reduce recovery values and should be reflected in eligibility or advance rates.

FIFO, LIFO and weighted average with rising costs

1. Beginning inventory: 100 units at $10. Purchases: 200 units at $12, then 200 units at $14. Units available = 500; total cost = 1,000 + 2,400 + 2,800 = $6,200. Units sold = 350.
2. FIFO COGS = 100 x 10 + 200 x 12 + 50 x 14 = 1,000 + 2,400 + 700 = $4,100. Ending inventory = 150 x 14 = $2,100.
3. LIFO COGS = 200 x 14 + 150 x 12 = 2,800 + 1,800 = $4,600. Ending inventory = 50 x 12 + 100 x 10 = 600 + 1,000 = $1,600.
4. Weighted average cost = 6,200 / 500 = $12.40. COGS = 350 x 12.40 = $4,340. Ending inventory = 150 x 12.40 = $1,860.
5. LIFO reserve = 2,100 - 1,600 = $500. LIFO pre-tax income is $500 lower than FIFO; at a 25% tax rate, taxes are 500 x 0.25 = $125 lower.
6. Check: in each method COGS plus ending inventory equals $6,200.

How underwriters apply this

• Convert LIFO reporters to FIFO using the LIFO reserve before comparing margins or inventory turnover with peers.
• Remove LIFO liquidation gains and reserve releases without corresponding sales from normalized EBITDA.
• Test reserves against aging and actual write-off history over several periods.
• Watch for overhead absorption gains when production exceeds sales in manufacturers.
• Base borrowing availability on appraised net orderly liquidation value, not book cost.

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Educational content written by practitioners. Not investment, accounting, legal or tax advice.