LIFO accounting, or last in, first out, refers to a method of accounting inventory valuation that’s based on the principle that the last asset acquired (the newest), is the first asset sold.
What is LIFO, Really?
What is the LIFO method in accounting? The LIFO accounting method is usually applied to a company’s inventory valuation processes. There are many different valuation methods applied to inventory, and, in most cases, management has to decide on what the most suitable method to use is.
With LIFO, the valuation is based on the concept that the last unit of inventory received (the latest inventory) is the first unit of inventory used. This method can produce a number of tax benefits thanks to the impact of profitability on the income statement.
Why is LIFO Beneficial?
Hypothetically, the cost to purchase inventory will go up over time. The strategy related to the LIFO valuation method is founded on the idea of selling your most expensive inventory first. After selling the inventory, the price or value of the units sold is turned over to the Cost of Sales account and charged on the company’s income statement. This means that the more expensive inventory is charged before the less expensive ones, resulting to lower profits and taxable income. This is why many companies prefer LIFO over FIFO for valuing their inventory.
Pretend you own a retail store and that you use the LIFO accounting method. Running a retail store is a profitable business, and you’re constantly looking for ways to reduce your tax burden every year. Experts suggest using the LIFO inventory method, so you run some numbers.
For example, you sell a widget for $5 each. You buy widgets from a manufacturer, and the purchase cost changes depending on the cost of materials used in making the widgets. Let’s say you purchased 100 widgets for $2 each, and then the next week you purchased 100 more for $3 each due to rising prices of materials.
The LIFO method produces less profit, and as a result, reduces a business’ taxable income.
Why Use LIFO?
The LIFO accounting method is used in calculating the COGS (Cost of Goods Sold) when the costs of producing or obtaining inventory increased due to inflation.
Although this accounting method may mean a decrease in profits for your business, it also means that you have less corporate tax to pay. In case the cost increases last for a long time, these savings could be quite beneficial for your business
Is the LIFO Method Legal?
The LIFO method is only allowed to be used in the United States, under rules decided by the GAAP (Generally Accepted Accounting Principles).
GAAP has introduced accounting standards to make it easier for companies to compare financial statements with each other. In other words, all companies abide by the same set of rules. GAAP set standards for a wide range of topics, including assets and liabilities to foreign currency, and presentation of financial statements.
The LIFO method is not allowed outside the United States. Most countries, including India, Russia, and Canada, must abide by the rules set down by the IFRS (International Financial Reporting Standards) Foundation. This foundation provides a system for internationally accepted accounting standards.
While the two standards have many differences between them, the IFRS is considered to be based more on ‘principles’, while the GAAP is more on ‘rules.’
LIFO vs FIFO: What’s the Difference?
LIFO means “Last-in, First-Out”.
FIFO means “First-in, First Out”.
The LIFO works based on the assumption that the most recent (or latest) products in a company’s inventory have been sold first and use those costs in the calculation of COGS (Cost of Goods Sold).
The FIFO method, on the other hand, does the opposite. The FIFO method works on the assumption that the oldest products in a company’s inventory has been sold first and uses those to lower cost numbers.
Is LIFO better than FIFO?
Maybe. Maybe not. The answer really depends on the market conditions.
The LIFO method is appealing for American businesses due to the fact that it gives tax breaks to companies that observe the costs of purchasing products or manufacturing them increase. But under the LIFO accounting method, bookkeeping is a lot more complicated. This is partially due to the fact that older products have a tendency to never leave inventory. That inventory value, as the cost of producing them increase, will also be understated.
The LIFO method may not accurately represent the real cost a company paid for a product as well. This is because the LIFO method is actually not related to tracking physical inventory, just inventory totals. In other words, a business can sell older products but make use of the recent prices of acquiring them in calculating the COGS (Cost of Goods Sold). This simply means that the generated COGS number is not accurate.
These are just some of the reasons why the LIFO method is controversial and deemed unreliable by many experts. This is the reason why this practice is prohibited outside of the United States.
The FIFO method is considered more reliable because when a company sells off and accounts for older products first, the resulting costs gives you a more realistic idea of a company’s finances. This includes the value of their current inventory. Companies can use such information to plan for the future.
Companies that Benefit from LIFO
Virtually any business that sell products that increase in price every year can benefit from LIFO accounting. When prices go up, a business that uses LIFO is able to match their revenues to their recent costs better.
Businesses can also save on taxes that they would have collected under other types of cost accounting, and they can take on less inventory write-downs.
Many supermarkets and pharmacies make use of the LIFO method because almost every product they stock experiences inflation. Many convenience stores also use LIFO because the costs of products such as tobacco and fuel have risen significantly over time.