Accounting for inventory encompasses a host of methods that are applied by companies for financial reporting. LIFO or the Last In First Out is one such accounting method that accounts for valuating inventory.
We will cover the following items in this article:
- What is Inventory valuation
- Different methods of Inventory Valuation
- What is LIFO?
- Benefits of FIFO
- Examples of LIFO
- IFRS and its purpose
- Reasons for IFRS banning LIFO
What is Inventory Valuation?
Inventory valuation enables a company to assess the monetary value for the goods in the inventory.
Inventory valuation is done to determine accurate values which in turn ensure authentic and detailed financial statements. A major chunk of important business decisions is based on the inventory cost measurement; in the absence of which it would be difficult to tally the expenses and revenue.
What are the different methods of Inventory Valuation?
The most commonly used methods under this system are:
- LIFO (Last-in First -out)
- FIFO (First-in First-Out)
- HIFO (Highest-in First-out) and
- Average Cost
All the methods mentioned generate different results as all of these are based on different assumptions of cost flow. We will be focusing on and learning more about LIFO in this article.
Inventory management would require most companies to use one or the other of the above methods.
Depending on the industry, accounting practices and for inventory control, companies usually stick with one method.
Note: Inventory valuation methods are different from inventory accounting systems, which could be the periodic system, or the perpetual system.
What is LIFO?
The LIFO method records for the inventory where the most recently purchased goods are sold first. This is to say that the newest products are the first to be cleared. This will eventually lead to the lower-priced older products getting recorded as inventory.
Typically, organizations with large inventories use LIFO, such as automobile dealers. This industry area can benefit because of lower taxes when the costs rise and because of higher cash flow.
Let’s understand the concept better with the examples here.
Examples of LIFO
We can understand LIFO through two examples:
- One where the cost of procured products increases
- The other when the cost of procured products decreases
Scenario 1: Purchase cost increases with time
Let’s say a company deals in gadgets and has a total of 10 gadgets to sell.
5 gadgets arrived 2 days ago and were priced at $100 each. The other 5 arrived 1 day ago and cost $200 each.
The company makes a sale of 7 units.
So going by the LIFO method,
The latest arriving 5 gadgets costing $200 were sold first, plus the 2 gadgets costing $100.
5*200 + 2*100
So, total sale = $1200.
Scenario 2: Purchase cost decreases with time
Let’s consider the same scenario but with decreasing costs of the products.
From the 10 gadgets which the company has, 5 arrived 2 days ago and cost $200 each. The other 5 arrived 1 day ago and cost $100 each. The company makes a sale of 7 gadgets.
So, applying LIFO to these values:
The latest arriving 5 gadgets that cost $100 each are sold first along with the 2 gadgets costing $200.
5*100 + 2*200
So, the total sale now = $500 + $400 = $900.
This observation concludes that LIFO generates more revenue in times of increasing prices and results in a lower valuation of remaining inventory. This could be an advantage in terms of tax payables.
Benefits of LIFO
The biggest advantage of LIFO is that it can offer you tax advantages. This happens as explained in the following steps:
- During inflation, when the prices of the goods are increasing, the LIFO method tells you to sell the more expensive or the latest goods first.
- This leaves you with the low-priced inventory which signifies lower net income.
- The higher the cost of sold goods, the lower is the net income.
- Lower net income means smaller tax liability.
Let’s move on to the next section which explains the difference between FIFO and LIFO.
FIFO vs LIFO
Here are the key points that highlight the differences between the two inventory valuation techniques.
- LIFO is a method of stock valuation that sells the stock received last. On the other hand, the FIFO method uses the approach of selling the goods in a serialized or chronological order.
- The stock in LIFO is the oldest, while in FIFO the latest stock is the stock in hand.
- The LIFO market price shows the costs of goods sold (COGS) while the FIFO price shows the current market price for unsold stocks.
- The LIFO method is not permitted to estimate an inventory but this is not the case with FIFO under the International Financial Reporting Standards.
- LIFO will demonstrate the right profit and thus contribute to tax saving if the economy witnesses inflationary trends. But in FIFO, it's exactly the opposite.
- Unlike LIFO, FIFO maintains a small number of records.
Why does IFRS ban LIFO?
Although permitted to be used in the US, the LIFO method is prohibited under IFRS- International Financial Reporting Standards. To understand why let’s take a quick look at IFRS and its purpose.
What is the IFRS?
IFRS establishes rules to bring all the financial standards under one roof. This is to say that it brings consistency in the accounting standards irrespective of the country or the company. IFRS benefits organizations by encouraging and maintaining corporate and financial transparency.
The Accounting Standards Board (IASB) is the entity that issues the IFRS. The board is also in charge of record-keeping, account reporting apart from the other essential aspects related to accounting.
IFRS bans LIFO owing to the possibility of misrepresentations of a company’s financial statements. LIFO may take the liberty to underrate the income of the company to attract lesser tax. It may also report the inventory valuation for the outdated or obsolete stock.
To sum up, here are the primary reasons for LIFO being banned by IFRS
- Understates net income for minimizing taxable income
- Presents outdated balance sheets resulting due to obsolete inventory valuation
- Creates opportunities for internal management through LIFO liquidation
NOTE: Any information provided here is as is and not to be taken as tax advise. It is always prudent to consult your CPA or accountant.
Key Takeaways
In a nutshell, this article talked about:
- LIFO - Last in First Out is an accounting method that considers selling the stock first that was most recently purchased.
- In the examples, we saw that LIFO generates a higher revenue in an inflationary market, thereby recording lower income and saving on the tax amount.
- We also saw that FIFO is preferred over LIFO by most organizations.
- IFRS- the standards which regulate the techniques of accounting for all companies, has prohibited LIFO owing to its shortcomings.
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