Inventory is one of the most valuable assets of a company, however, this can also be the most important line item in a company’s balance sheet. With LIFO accounting, the business can be provided with a valuable means of generating cash as this approach can leverage the existing inventory of the company for profit which makes this approach also good for businesses in various industries who are looking to reduce their Federal and State tax liabilities.
LIFO Accounting: How It Works
LIFO is an abbreviation for “Last In, First Out” and it refers to a technique of accounting predicated on the assumption that freshly bought inventory is sold before that which was bought previously. During periods of growing inflation, the idea states that higher-priced inventory will be sold and distributed, whereas earlier and lower-priced items will comprise the inventory’s ending level.
The LIFO technique has little influence on the actual distribution of products; it is merely a cost flow method for accounting, and a corporation is not compelled to hold on to outdated inventory in order to receive tax benefits.
Understanding LIFO Accounting and FIFO Accounting
First In, First Out (FIFO) is the opposite inventory approach of Last In, First Out (LIFO), since it presupposes that the first items purchased will be the first to be sold. In times of inflation, the FIFO accounting method will result in higher values for ending inventory compared to the LIFO method, which capitalizes more costs on inventory but offers fewer tax savings.
This makes LIFO a more favorable strategy, especially when prices rise because it assigns a lower value to leftover inventory, which results in a greater Cost of Goods Sold. This can have a direct impact on decreasing a company’s taxable income and annual tax liability.
Understanding the Concept of LIFO Reserves
The difference in inventory cost between the LIFO and FIFO inventory methods is called the LIFO reserve and this illustrates the cumulative tax advantage when implementing the LIFO accounting method. Despite the fact that many organizations use FIFO to track inventory, LIFO is the most common method for calculating income, and with a LIFO Reserve, a corporation will rise from one year to the next while inflation is rising.
Three Methods of LIFO Accounting
There are three main LIFO methods that give advantages to businesses in certain industries. One way may be established as the standard, or a company may choose to switch its preferred method when the required number of years have passed:
- Automotive LIFO
In delivering the best benefits to businesses in a certain area, the automobile sector employs the LIFO approach; furthermore, they also have their approach in employing a model that incorporates the base cost model of a motor vehicle every year, per manufacturer, and per brand that applies to both new and used inventories.
- Method for Calculating Internal LIFO
By comparing the cost of items acquired at the beginning of the year to those purchased at the end of the year, the rate of inflation may be precisely determined through an internal corporate inventory study. Using this information, a corporation may be able to reduce the cost of items in certain categories that may not be represented by an aggregated technique.
- Inventory Price Index Calculation or the IPIC Method
The most preferred approach by the IRS is the IPIC method which is done by using monthly indices from the Bureau of Labor Statistics to evaluate inflation in their inventory for the year. Keep in mind that the BLS categories represent the domestic inflation rate and do not include international manufacturing or purchasing. Although the categories may not be an equal depiction of inventory, the BLS indices nearly always demonstrate a higher inflation rate and, hence, a bigger gain from LIFO.
Pros and Cons of Employing the LIFO Accounting Method
Benefits of Employing the LIFO Accounting Method
Below are the points enumerating the advantages of employing the LIFO accounting method:
1. This strategy is also quick and easy to implement, especially when prices are somewhat stable.
2. According to this system, materials are billed to production at the most recent rates paid.
3. Under this strategy, quoting rates for a company’s goods will be secure and lucrative during periods of rising pricing.
4. This strategy, just like FIFO, does not generate exaggerated profits or losses.
5. This strategy is simple to use when purchases are made less often.
6. Due to the influence of inflation on manufacturing costs, the decreased profit margin leads to tax savings.
Downsides of the LIFO Accounting Method
1. According to this procedure, closed stock is evaluated at previous values, which do not reflect its current economic value.
2. This strategy is unrealistic since it contradicts the physical movement of materials.
3. Similarly with the FIFO technique, the material costs of similar jobs may vary due to the varied lots and, therefore, prices of the materials given. It complicates comparisons.
4. This strategy is complicated when there are frequent price variations.
5. Frequently, many prices must be applied to a single request for pricing.
6. When prices vary, the complexity of this strategy increases.
Effects of LIFO Method on Production Cost
The adopted implications of the LIFO approach on manufacturing costs are as follows:
- As the prices of the most recently acquired materials are utilized to determine the issue price, the issue price reflects the current market pricing. As a result, the manufacturing cost also reflects the current market price.
- In a rising market, manufacturing costs are inflated, whereas they are underestimated in a declining market.
Effect of the LIFO Method on Inventory Appraisal
The cost of closing stock does not represent the current market price because all of the most recently bought materials are used for issuance. Consequently, the closing stock is appraised at old rates but not at current material costs.
Effects of LIFO Method on Income
Below are the effects of the LIFO accounting method on income:
- A price increase may be offset by a price decrease over time, thus the overall profit will not be harmed by this strategy. As a result of charging varying rates for materials to various goods, however, the earnings of each product or work vary.
- During periods of rising prices, production is charged higher rates for inputs, hence increasing production costs. This reduces the profit margin, resulting in a tax deduction.