Inventory Costing Methods: Is it time to consider LIFO? (2024)

FAQs

Is LIFO an acceptable inventory costing method? ›

LIFO is banned under the International Financial Reporting Standards that are used by most of the world because it minimizes taxable income. That only occurs when inflation is a factor, but governments still don't like it. It also can make a company's inventory valuations inaccurate.

LIFO understates profits for the purposes of minimizing taxable income, results in outdated and obsolete inventory numbers, and can create opportunities for management to manipulate earnings through a LIFO liquidation. Due to these concerns, LIFO is prohibited under IFRS.

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. The lower your profits, the less you'll owe in taxes.

For most companies, FIFO is the most logical choice since they typically use their oldest inventory first in the production of their goods, which means the valuation of COGS reflects their production schedule.

LIFO can be beneficial since the most recent higher-priced items will be considered sold and removed, leaving the lower-cost items as your ending inventory. This means a higher Cost of Goods Sold, which reduces your business's taxable income.

FIFO usually provides a more accurate valuation of leftover inventory, since the value of unsold inventory is closer to the purchase price. The LIFO method, however, does not always provide an accurate valuation of ending inventory since older goods tend to be stored repeatedly as inventory.

Disadvantages of LIFO

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.

Opponents of LIFO say that it distorts inventory figures on the balance sheet in times of high inflation. They also point out that LIFO gives its users an unfair tax break because it can lower net income, and subsequently, lower the taxes a firm faces.

While LIFO has many benefits, one should be aware of its limitations as well. Misleading inventory data and incompatibility with international standards are some of the limitations of the LIFO method. Investors also find it difficult to comprehend this accounting method.

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.

Do most people use LIFO or FIFO? ›

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.

Insight on LIFO Method Example

If 80 loaves were sold using LIFO, the first 50 would come from the second (latest) purchase costing $2 each, and 30 would come from the first purchase costing $1 each. Therefore, the total cost of goods sold would be 50 loaves * $2 + 30 loaves * $1.

The Bottom Line

The FIFO method assumes that the oldest inventory units are sold first, while the LIFO method assumes that the most recent inventory units are sold first. FIFO tends to reflect current market prices better. LIFO better matches current costs with revenue and provides a hedge against inflation.

LIFO gives the most realistic net income value because it matches the most current costs to the most current revenues. Since costs normally rise over time, LIFOs can result in the lowest net income and taxes.

IAS 2 prohibits LIFO; US GAAP allows its use.

While the majority of US GAAP companies choose FIFO or weighted average for measuring their inventory, some use LIFO for tax reasons.

Last In First Out (LIFO) method is not used in process costing, since the underlying assumption of process costing is that "the first unit prodoced is, in fact, the first unit used, which is the FIFO concept.

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.

The disadvantages of using LIFO are that it increases the risk of inventory obsolescence, it shows a lower net income and a higher cost of goods sold in periods of rising prices, and it is complex to apply and understand, especially for international accounting standards.