What Is Highest In, First Out (HIFO)?
Let me explain what highest in, first out (HIFO) really means. It's an inventory distribution and accounting method where you take the inventory with the highest purchase cost out of stock first. This approach affects your company's books by ensuring that for any period, the inventory expense hits the highest possible level for cost of goods sold (COGS), while leaving the ending inventory at the lowest possible value.
You won't see HIFO in use very often—it's rare to non-existent—and it's not recognized by GAAP.
Key Takeaways
- Highest in, first out (HIFO) accounts for inventories by removing the highest-cost items from stock first.
- HIFO helps a company lower its taxable income by realizing the highest possible cost of goods sold.
- HIFO is extremely rare and not accepted under general accounting practices like GAAP or IFRS.
Understanding Highest In, First Out
Deciding how to account for inventories is a critical choice for any firm, as it directly influences your financial statements and key figures. You'd likely opt for the highest in, first out (HIFO) method if your goal is to decrease taxable income over a specific period. Since the inventory recorded as used is always the most expensive you have—regardless of purchase timing—you end up booking the maximum cost of goods sold every time.
Keep in mind that companies sometimes switch inventory methods to smooth out their financial performance. Compare this to other methods like last in, first out (LIFO), where the newest inventory gets used first, or first in, first out (FIFO), which uses the oldest inventory first. LIFO and FIFO are standard and common, with LIFO even being part of GAAP. HIFO, however, is seldom used and isn't recognized by GAAP as a standard practice.
Some Highest In, First Out Implications
If a company chooses HIFO to cut taxable income, there are several implications you need to be aware of. First, since it's not GAAP-recognized, your books might face heavier scrutiny from auditors, potentially leading to something other than an unqualified opinion. Second, in an inflationary setting, the inventory acquired earliest could become obsolete. Third, your net working capital drops because of the lower inventory value. Finally, if you depend on asset-based loans, that reduced inventory value means you'll qualify for less borrowing.
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