The LIFO inventory accounting method is beneficial for
businesses that have new inventory. If prices and inflation rise, calculating
inventory costs at the highest prices reduces profits and taxable income.
What Is Last In, First Out (LIFO)?
LIFO stands for "last in, first out" in inventory
accounting. Companies use this accounting method to expense inventory items
that they have recently purchased or manufactured. On financial statements,
companies use the accounting method to expense the most recent inventory as the
cost of goods sold (COGS).
In the United States, LIFO is one of three generally
accepted accounting principles (GAAP). The other two are the "first in,
first out" (FIFO) method (in which companies sell their initial inventory
first) and the average cost method (in which business owners average unit costs
from beginning to closing inventory). LIFO inventory management typically
reduces net income but is advantageous for tax purposes during periods of
inflation or rising prices.
What Is the LIFO Method and How Does It Work?
LIFO is a commonly accepted accounting principle (GAAP) in
the United States. It is a method of reporting that aids inventory valuation.
However, the LIFO method is not permitted by International Financial Reporting
Standards (IFRS) because it can distort financial statements.
When taxes rise, using LIFO reduces taxable income while
increasing cash flows. When there is no inflation, income statements and cost
flow cancel out, and the method of inventory costing does not matter. However,
if inflation is high and large or small businesses have excess inventory, LIFO
can result in lower net income taxes because COGS (cost of goods sold) is
higher.
Example of the LIFO Method
LIFO is an accounting principle that can increase inventory
values. As an example of LIFO, suppose the fictional FastSpeed Car Company has
one hundred used cars in inventory to sell. Consider the following aspects of
revenue generation, from inventory creation to sales:
Inventory: The first fifty cars produced by the company cost
$10,000 each. The last fifty vehicles manufactured by the company cost $20,000
each. The last cars manufactured by the company should be the ones sold first
under the LIFO inventory management method.
Inventory costs: In this example, FastSpeed Car Company
sells a total of eighty cars. Because all vehicles have the same sales price,
revenue is the same; however, the cost of the vehicles to the company is
determined by the inventory method used. According to the LIFO method, the last
inventory (the more expensive cars) should be the first to sell.
Sales: Using the LIFO method, the company sells fifty cars
that cost $20,000 to make first, then thirty cars that cost $10,000 to make.
The total inventory is worth $1.3 million (50 at $20,000 and 30 at $10,000).
Paying a lower taxable income fee by selling ending inventory when inflation and
prices are up can benefit the company's balance sheet using LIFO accounting.
This is advantageous because it lowers the total cost of taxable income when
reporting to the IRS.
LIFO vs. FIFO Accounting Methods
Both the LIFO (last in, first out) and FIFO (first in, first
out) methods are used to value inventory, but there are a few key differences:
Price of goods sold: Using LIFO, each item sold by a company
raises the cost of goods sold. Companies compute ending inventory based on the
cost of the oldest inventory. The unit cost of the oldest inventory determines
the COGS in the FIFO method. The company is less likely to lose money if older
products expire.
Order of inventory: Companies that use the LIFO inventory
method sell the most recently received inventory first. Companies use FIFO to
sell the oldest inventory first.
Net income: Generally, LIFO reduces net income, whereas
selling the oldest inventory first increases net income.
Taxes: In times of high inflation, the LIFO inventory method
results in lower profits, which translates to lower taxes. This tax savings
benefits businesses because, when selling a large number of products in
inventory, the amount companies owe in taxes decreases as prices rise. The FIFO
method increases net income, which can be beneficial, but it also means that the
company must pay more in income taxes.
