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LIFO Method: Definition – Explanation – Example

LIFO Method – What Is Last In, First Out?

LIFO MethodThe LIFO Method of accounting stands for last-in, first-out. It means the latest purchased or produced goods are considered as sold and expensed first.  In other words, the cost of the most recent product acquired (or created) is the first to be expensed as the cost of goods sold (COGS).  As a result, it means that the lower cost of older products is reported as inventory and stays on the balance sheet. This differs from the average cost method which takes the weighted average of all units available for sale.  It then uses that average cost to determine COGS and ending inventory for the accounting period under consideration. Another system is called the FIFO method. FIFO takes the oldest inventory items recorded as sold first to determine COGS and ending inventory.

Companies employ the LIFO method because it is assumed that the cost of the inventory rises over time.  This is a legitimate assumption in times of inflation and rising prices. When utilizing the LIFO method, the most recently acquired inventory will always be more expensive than earlier purchases.  As a result, the final inventory balance will be valued at earlier costs.  However, the most recent expense appears in the cost of goods sold. A corporation can reduce its stated level of profitability and hence defer the recognition of income taxes.  This is a direct result of shifting high-cost inventory into the cost of goods sold. Income tax deferral is usually the primary rationale for employing the LIFO method of inventory valuation.  The LIFO method is prohibited by international financial reporting standards.  However, it is still allowed in the United States under the approval of the Internal Revenue Service.

LIFO Method and the IRS

A taxpayer who chooses the LIFO method for tax purposes must adopt the LIFO method in its financial statements in general.

  • LIFO method with no other valuation technique – The LIFO compliance standards apply to the taxpayer’s first taxable year using the LIFO method. A taxpayer must demonstrate that it only uses LIFO and no other inventory technique. The conformance rules apply to all income, profit, or loss reports or disclosures to shareholders, beneficiaries, or credit holders.
  • Only LIFO going forward – the LIFO compliance standards apply to taxable years in the future. Once a taxpayer has chosen LIFO, they must continue to use it for financial reporting unless the taxpayer also moves to a non-LIFO technique for tax purposes.

If a taxpayer fails to comply with the LIFO reporting requirement, the IRS may order the taxpayer to convert its LIFO accounting system to a non-LIFO method for tax reasons.

A taxpayer electing the Last in – First out (LIFO) method for tax purposes must generally use the LIFO method in its financial statements. Treas. Reg. 1.472-2(e) covers the financial statement conformity requirements for a taxpayer using the LIFO inventory method. First, the LIFO conformity rules apply to the first taxable year the taxpayer adopts LIFO. A taxpayer must establish that it is using only LIFO and no other inventory method. See IRC 472. The conformity rules apply to all reports or statements of income, profit, or loss to shareholders, beneficiaries or credit holders. There are some exceptions to this rule as noted later. Second, the LIFO conformity rules apply to future taxable years. Once a taxpayer has elected LIFO, it must continue to report under this method for financial reporting unless the taxpayer also changes to a non-LIFO method for tax purposes. (Source: irs.gov)

LIFO Method – A Closer Look 

The LIFO method of inventory valuation is only utilized in the United States.  All three inventory-costing systems are permissible under generally accepted accounting standards (GAAP). However, the LIFO method is prohibited under the International Financial Reporting Standards (IFRS).  LIFO inventory valuations are often used by companies with relatively big inventories, such as retailers or auto dealerships.  These businesses can benefit from cheaper taxes when prices rise and increase cash flows. However, many US corporations choose a first-in,first-out (FIFO) method.  If a company uses a LIFO valuation when filing taxes, it must use the same method when reporting financial results to shareholders.  While potentially favorable for tax purposes, the LIFO method reduces net income and earnings per share.

FIFO Method (First-in, first-out)

The first-in, first-out (FIFO) inventory valuation approach is based on the cost flow assumption.  It presumes that the first things purchased are also the first products sold. This assumption closely reflects the actual flow of goods in most businesses.  As a result, it is the most theoretically sound inventory valuation technique. Further, the FIFO flow concept is a sensible one for a corporation to follow.  This is because it decreases the risk of inventory obsolescence by selling off the oldest goods first.

Average Cost (AC) Method

The average cost method applies the average cost to each item within a group of assets. The technique is most typically employed with inventory, although it can also be used for fixed assets. For example, consider three items that have individual costs of $20, $22, and $24.  Average costing would require that the cost of all three widgets be regarded as if they were $22 each.  That is the average cost of the three items. The average costing approach needs little effort.  Therefore, it is one of the least expensive cost accounting methodologies to maintain.  This is compared to the other major cost accounting methods, FIFO and LIFO. Furthermore, the average costing method does not result in a number of cost layers, making data maintenance easier. Another advantage is that it is more difficult for someone to falsify the reported degree of profit or loss.

LIFO Method vs FIFO Method vs AC Average Cost

When inflation is zero, all three inventory-costing approaches provide the same outcome. However, if inflation is substantial, the accounting system chosen might have a significant impact on valuation ratios. The effects of FIFO, LIFO, and average cost differ:

  • FIFO First-in first-out – provides a better indicator of the value of ending inventory on the balance sheet.  However, it also boosts net income by using inventory that may be several years old to value COGS. Increasing net income sounds fantastic, but it can raise a company’s tax burden.
  • LIFO Last-in first-out – Because it may understate the value of inventory, is not a good indicator of ending inventory value. Because COGS is higher in LIFO, net income (and taxes) are lower. During inflation, however, there are fewer inventory write-downs under LIFO.
  • AC Average cost method – The average-cost technique is sometimes known as the weighted average cost method.  It is a GAAP accepted accounting method used to establish the average inventory value. This figure is calculated by dividing the total cost of products throughout an accounting cycle by the total number of goods. Average cost produces results that fall somewhere between FIFO and LIFO.

LIFO Method Example 

Consider a small motorcycle dealer with 10 motorcycles. The first five motorcycles cost $2,500 each and arrived two weeks ago. The last five motorcycles cost $3000 each and arrived one day ago. Based on the LIFO inventory management method, the last motorcycles are the first ones to be sold. Eight motorcycles are sold that month.

Each motorcycle has the same sales price, so revenue is the same.  However, the cost of the motorcycles is based on the inventory method selected. Using the LIFO method, the last inventory is the first inventory sold. This means the motorcycles that cost $3000 were sold first. The company then sold three more of the $2,500 units. In total, the cost of the motorcycles under the LIFO method is $22,500, or five at $3000 and three at $2,500.

In contrast, using the FIFO method, the $2,500 motorcycles are sold first, followed by the $3,000 units. Using the FIFO method, the cost of the motorcycles sold will be recorded as $21,500, or five at $2,500 and three at $3,000. This is why, during periods of rising prices, LIFO generates higher costs and decreases net revenue, lowering taxable income. Similarly, in times of declining prices, LIFO reduces costs and improves net income, which boosts taxable income.

Up Next: What Is Receivership?

Receivership

Receivership is a court-appointed condition placed on a company to protect property controlled by a person sued in court. It is a legal remedy available to secured creditors to recover outstanding amounts in the event the company defaults on its loan payments.  Receivership and bankruptcy are not synonymous, nor are they mutually exclusive. They can occur concurrently, or a receivership can occur without a corporation going bankrupt.

A receivership is a court-appointed mechanism that can help creditors recover overdue funds.  At the same time, it can help distressed businesses avoid bankruptcy. If a borrower fails on a loan, a receivership in place makes it easier for a lender to recover outstanding funds. A receivership may also occur as a step in the restructuring process of a corporation.  This procedure is launched in an attempt to return a company to profitability. A receivership may also be imposed as a result of a shareholder disagreement.  For example, in order to complete a project, liquidate assets, or sell a corporation.

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