LIFO, FIFO, and the World of Financial Accounting

I am about to attempt the impossible here, people. We are about to make history here together, so get ready. Strap on your safety belts, get yourselves in crash position, and prepare to be amazed. Right here, right now, I am going to attempt to explain Financial Accounting principles to you. I know it's frightening. I know it's intimidating. But we are going to get through this together, I promise.

There are three main types of accounting systems that retail businesses use when calculating their income: LIFO, FIFO, and Weighted Average. I wasn't paying super close attention when my professor was talking about weighted average because I was having a computer malfunction at the time, so we're just going to stick with LIFO and FIFO for now.

FIFO: First In, First Out
Now, as I go through this explanation, there are two basic business ideas that we have to keep in mind:
1. prices tend to go up as time goes on. As a business buying things wholesale, you can expect that over time the price of buying your inventory will increase.
2. In order to calculate your income as a merchandising business, you must record how much you made in sales, and then subtract your Cost of Goods Sold (how much it cost to buy your inventory), and your operating expenses.
So, the First in, First out system means that the first inventory you buy is the first inventory you try and sell. This means that you are selling your cheapest inventory first, and keeping your most expensive inventory, which keeps your Cost of Goods Sold (COGS) relatively low. With a low COGS, you don't have very much to subtract from your Sales, which makes your income appear high.

LIFO: Last In, First Out
In this system, the most recent inventory you purchase (in other words, the inventory that cost you the most to buy) is the first inventory you choose to sell. By doing this, you make it appear that it is costing a lot to buy your inventory, which you then subtract from your sales, and this makes your income appear very low.

So which system do you think is better? I'll give you a hint: the LIFO system is illegal in most countries outside the US. Why? Because the LIFO system makes your income appear to be low, which means there is less for the business to pay income taxes on, when in reality the business didn't pay any more for its inventory in one system than the other. Here's an example:

Let's say my company made $5,ooo in sales this year. For my inventory I bought 100 skeins of yarn at $10 each = $1000. The next time I purchased that same yarn, the price had gone up and I bought 200 skeins for $11 each = $2200. And the third time I bought the yarn I got 100 skeins at $12 a skein. If I then sell 200 skeins, I have to decide which skeins to record as a sale. Using the FIFO system, I would first record the $10 skeins, then the $11 ones, and so on and so forth. Using the LIFO system I would first record the $12 skeins, then the $11, etc. So, let's see what this does to the income statement:
FIFO LIFO
Sales $5000 $5000
COGS -$2650 -$2850
Operating Expenses -$1000 -$1000
Income $1350 $1150

As you can see, although we made the same amount in sales, and incurred the same amount in operating expenses, by choosing to express the most expensive inventory as sold first, we made our income seem smaller than it really is, thereby lowering the amount we have to spend in taxes.

Needless to say, many people regard the LIFO system as a cheap trick to cheat the system, and as we speak Obama is working on a way to make the LIFO system illegal in the US. This is very clever on his part, as the government will gain more money in tax revenue, but they won't actually be "raising taxes." Cool, huh?

Ok, I'm sorry if this was super confusing, I tried to make it simple, though I don't know if I succeeded. I just think it's really interesting! So, this is the reason I haven't posted in so long, because I have been trying to figure out a way to explain this and it took me forever. I'll try to start posting more regularly.

(P.S. Thank you to Professor Mona, the most amazing accounting professor ever, for supplying the example. I actually simplified it a little, but that's the general idea.)