How Can Switching to the LIFO Inventory Method Benefit Your Business? | Bennett Thrasher (2024)

FAQs

How Can Switching to the LIFO Inventory Method Benefit Your Business? | Bennett Thrasher? ›

LIFO allows a business to deduct the most recently purchased items of inventory which in times of price inflation allows for a greater cost of goods sold deduction than could be realized under the FIFO method.

The most noteworthy advantages of LIFO include: Tax savings. If the cost of your products increases over time, the LIFO method can help you save on taxes. This is because applying the most recent or higher inventory costs to the items you've sold will cause your profit margin to go down.

When prices are rising, a business that uses LIFO can better match their revenues to their latest costs. 3 A business can also save on taxes that would have been accrued under other forms of cost accounting, and they can undertake fewer inventory write-downs.

Most companies that use LIFO inventory valuations need to maintain large inventories, such as retailers and auto dealerships. The method allows them to take advantage of lower taxable income and higher cash flow when their expenses are rising.

LIFO results in lower inventory costs on the balance sheet because the latest, higher costs were removed from inventory ahead of the older lower costs.

LIFO can help you get a better measurement of the current earnings of your business. Moreover, it helps to reduce inventory profits by aligning current business revenue with current costs.

During inflationary periods, an advantage of the LIFO inventory cost method is that it matches more recent costs against current revenues. During inflationary periods, the use of the FIFO method of costing inventory will result in a greater amount of net income than would result from the use of the LIFO cost method.

Most companies prefer FIFO to LIFO because there is no valid reason for using recent inventory first, while leaving older inventory to become outdated. This is particularly true if you're selling perishable items or items that can quickly become obsolete.

The main disadvantage of using the LIFO valuation method is that it is incompatible with International Financial Reporting Standards and not accepted under the tax laws of many countries. There is also the risk that older inventory items will get damaged or become obsolete.

Tax and Cash Flow Implications

FIFO results in higher ending inventory values and higher net income. This increases taxable income and taxes owed. LIFO results in lower ending inventory on the books and lower net income. This reduces taxable income and income tax expenses.

What is the primary reason for popularity of LIFO? ›

Saves income taxes currently. This is the correct option. Under LIFO, the company gets to deduct the cost of their latest purchases as part of the Cost of Goods Sold, and because goods tend to become more expensive, this leads to a higher Cost of Goods Sold expense, and therefore lower profits for the current year.

IFRS prohibits LIFO due to potential distortions it may have on a company's profitability and financial statements. For example, LIFO can understate a company's earnings for the purposes of keeping taxable income low. It can also result in inventory valuations that are outdated and obsolete.

FIFO is the most logical choice since companies typically use their oldest inventory first in the production of their goods. Deciding between these two inventory methods as implications on a company's financial statements as this decision impacts the value of inventory, cost of goods sold, and net profit.

Tax Benefits: LIFO allows a business to match its most recent inventory costs with current revenue, resulting in lower reported profits and lower income tax liability. This can help businesses reduce their tax expenses in times of rising prices.

The LIFO method assumes that the most recently purchased inventory items are the ones that are sold first. With this cash flow assumption, the costs of the last items purchased or produced are the first to be counted as COGS. Meanwhile, the cost of the older items not yet sold will be reported as unsold inventory.

If prices are rising through the year, using the recent inventory LIFO method will result in a higher COGS and lower ending inventory value than with the FIFO method. Using the LIFO accounting method here would yield lower profits and lower taxable income.

LIFO advantages:

In periods of inflation, LIFO costing results in a lower cost of goods sold and, therefore, higher net income. This is because the newest inventory, which costs more, is not recognized as an expense until you've sold it.

Taxes. The primary reason that companies choose to use an LIFO inventory method is that when you account for your inventory using the “last in, first out” method, you report lower profits than if you adopted a “first in, first out” method of inventory, known commonly as FIFO.

The weighted average inventory valuation method is a simple and easy to use method for valuing inventory. However, it may not be suitable for businesses with a high turnover rate or those that require more accurate inventory valuations.

Last-In, First-Out (LIFO) inventory deductions allow companies to deduct the cost of inventory at the price of the most recently acquired items and assumes that the last inventory purchased is the first to be sold. LIFO limits the impacts of volatile prices or inflation and lowers the tax cost of new inventory.