Last in, First Out or LIFO accounting is an accounting inventory valuation procedure that is based on the idea that the last asset acquired (the newest), is the first asset sold.
How Do You Define LIFO?
What is LIFO? What is its definition? The LIFO method is often applied to a company’s inventory valuation methods. There are many different valuation techniques applied to inventory, and usually management has to determine what method to use is the most advantageous. Under LIFO, the valuation is based on the idea that the last unit of the inventory received (the newest inventory) is the first unit of inventory used. Based on the unit cost and timing of inventory records, the LIFO method can produce several tax benefits thanks to profitability impacts on the income statements.
What makes the LIFO accounting method advantageous? Hypothetically, the cost to purchase inventory only goes up over time. The strategy used with the LIFO valuation method is based on the notion of selling the most expensive item on your inventory first. After selling the inventory, the value of the units sold is handed over to the Cost of Sales account and charged on the company’s statement of income.
This basically means that the more expensive inventory is levied before less expensive inventory, lowering profits and taxable income as a result. This is the reason why most companies use LIFO over FIFO for the valuation of their inventory.
What Are the Advantages of LIFO Accounting?
The LIFO method is commonly employed among companies worldwide for the following reasons:
It matches most recent costs versus current revenues
The LIFO method offers a better way of measuring current earnings by matching recent costs against current revenues.
Non-LIFO methods, like the FIFO method, match previous/old costs against current revenues. The inventory profit (also called ‘paper profit’ or transitory profit’) is created when this (old costs vs current revenues) happens in an inflationary environment. Inventory profit happens when the replacement cost of the inventory costs more than the inventory cost matched against the revenue. The inventory profit downplays the cost of the goods sold (COGS) and exaggerates profit.
This is where the LIFO method comes in—it helps reduce the inventory profits by matching the most recent costs against revenues. This leads to the reduction of the understatement of COGS and overstatement of profit. Thus, LIFO improves the quality and reliability of earnings.
Cash Flow Tax Benefits and Improvements
The reason why the LIFO inventory valuation method has gained popularity is due to its tax benefit. When used in the periods of inflation, LIFO matches the current purchases at higher prices against revenues that reduce the overstatement of profit, thus reducing the income tax bill. The reduction of income tax leads to better cash flows of the company.
It Reduces Write-downs to Market
When a company uses the LIFO method, its net income is less likely to be impacted by the decline in price in the future. More often than not, companies using the LIFO accounting method do not have a lot of inventory at current higher prices since, with this method, the most recent inventory purchased at a higher price is sold first. This, therefore, minimizes or even eliminates the chances of write-downs to market
Physical Flow of Inventory
In some cases, the physical flow of inventory is consistent with the flow of LIFO cost. Let’s take the coal pile as an example. Th most recent coal added to the pile is always on the top of the coal pile. For this reason, the last coal in is always the first coal that is taken out.
This reason is not why the LIFO method is popular because it’s very rare to come across situations where the physical flow of inventory correlates with the LIFO cost flow. The first three advantages that we mentioned above are the main reasons for the widespread popularity of this accounting method.
Disadvantages of the LIFO method
While the LIFO accounting method is popular and offers a lot of advantages, there are drawbacks to it as well. They are as follows:
Reduces Reported Earnings in Inflation Periods
The LIFO method is said to reduce earnings during the inflation period, which is why many companies fear that changing to LIFO will have a negative impact on investors and reduce the price of their company’s stock. This is probably because many investors do not understand how LIFO impacts inflation and reported earnings.
With the LIFO method of accounting, the balance sheet inventory figure is normally understated due to it being based on the oldest costs. Because of the understatement of inventory, the working capital may be in a bad position that it really is.
Issues with LIFO Liquidation
There may be issues with the LIFO Liquidation such that it inflates the reported income for a specific period, leading to higher tax payments for the period. To prevent this, a company may purchase goods in large quantities in order to match them against revenues. This means that adopting the LIFO method of accounting may lead to the poor buying habits among companies.
Companies using the LIFO method can easily manipulate its earnings reported for a period by means of changing its purchase pattern at the end of the year.
The LIFO method isn’t really a bad inventory system, but it can be a bit difficult to maintain. LIFO requires a more complicated means of record-keeping, because the inventory costs do not leave the accounting system ever. So, before you decide on using the LIFO method, do your research to determine whether it is the best choice for your company. Once you file for LIFO, you will not be able to change your decision without permission from the IRS.
While LIFO can be a bit complicated, it can also lead to an increase in savings if your company needs it. Make sure you and your company talk it through with a business tax professional before you make the move to LIFO as this can be a complex process.