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LIFO Accounting refers to Last-in, First-out inventory accounting systems. LIFO is a relatively newer inventory cost valuation method that started during the 1930s. This method for assessing inventory value assumes that the most recently purchased products are sold first. LIFO is often compared to FIFO, which is the more popular inventory accounting method.
LIFO Inventory
In order to understand LIFO, it’s necessary to first understand inventory management. Inventory refers to a supply of unsold products. Inventory is a standard business asset because it has monetary value. At the end of each accounting period, a company must determine the total cost of all the products in inventory in order to calculate the cost of goods sold. The cost of goods sold is calculated by using financial data from the beginning inventory, additional purchases to inventory and the final inventory count.
The beginning and ending inventory costs are important factors when using LIFO because the higher costs of goods sold reduces the company’s profits. The LIFO method intentionally lowers the recorded value of inventory, which helps businesses avoid higher income tax brackets because of annual inflation. There continues to be a political debate about the appropriateness of LIFO because certain industries take advantage of this gray accounting and taxation technique.
Tax Savings
LIFO is popular with companies that deal with frequent increases in the costs of their product. LIFO is favored by oil companies and supermarkets because their inventory costs are always on the rise. Any business can use LIFO, but there are more general advantages to the FIFO method. When calculating inventory costs, the LIFO method uses the costs of the most recent products purchased. This is favorable for industries that deal with inflation because LIFO will take advantage of the higher costs of recently purchased goods in order to lower gross profits and thus lower the amount of annual taxes owed.
LIFO is one of the largest tax breaks in the IRS’ corporate code, so many American businesses adamantly defend this practice. However, this practice is considered inaccurate by global standards, so it is not accepted under the International Financial Reporting Standards (IFRS). A company must subtract costs from gross revenues in order to determine taxable profits. LIFO allows companies to intentionally buy massive amounts of expensive inventory, which will increase taxable deductions.
LIFO vs. FIFO
In order to properly assess the assumed value of LIFO and FIFO inventory costs, businesses analyze how inventory costs in their industry change. First, if inventory costs are increasing, LIFO costing is better because the more recently purchased expensive items are treated as sold. This results in lower profits and higher costs. When inventory costs are going down, FIFO costing is better because it is more accurate and straightforward. LIFO inventory accounting increases the burden of taxation record keeping because older inventory items may be stored for several years.
On the other hand, FIFO inventory account treats these older items as already sold, so there are limited record keeping requirements. The IRS is becoming more opposed to LIFO valuation because it lower profits and thus decreases taxable income. The Financial Accounting Standards Board (FASB) allows both FIFO and LIFO inventory accounting.
Businesses must keep in mind that the IFRS, which is the global accounting standards body, doesn’t allow LIFO to be used. Companies with international locations or overseas joint-ventures will not be able to use LIFO accounting.