(Newswire.net — June 30, 2022) — LIFO Accounting is a system that registers the products that were created the most recently as having been sold first. This approach is utilized to account for how inventories have been sold. According to the International Financial Reporting Standards (IFRS), which are the guidelines for accounting that are used in the European Union (EU), Japan, Russia, Canada, and India among a great number of other nations, this practice is not allowed. The United States of America is the only nation in the world that follows generally accepted accounting principles, which enables it to use last-in, first-out accounting (LIFO) (GAAP).
The first-in, first-out (FIFO) technique and the average cost method are two variations of the LIFO approach that is available for use when calculating the cost of an inventory item. The oldest things in an inventory are the ones that are reported as having been sold first when using the FIFO accounting method.
The average cost method calculates the cost of goods sold or COGS and ending inventory by taking the weighted average of all units that were available for sale during the accounting cycle and then using that average cost to determine the total number of units that were in stock at the end of the period.
When prices are going up, it might be to a company’s advantage to employ LIFO since it allows them to take advantage of reduced taxes during that time. LIFO is utilized by a significant number of businesses, the most common of which are retail establishments and vehicle dealerships.
How the “Last in, First out” (LIFO) System Operates
The Last-In, First-Out (LIFO) accounting method requires a company to list the most recent products and inventories as the first things to be sold. In the first-in, first-out (or FIFO) technique, the item with the longest shelf life is counted as the one that sells first. Although it’s possible that the company isn’t selling the most recent or most outdated goods, for the sake of cost accounting, they adopt this assumption.
It wouldn’t make a difference whether a company utilized the LIFO or the FIFO technique to account for its inventory if the cost of purchasing it remained the same year after year. However, expenses do alter because the price of many things continues to climb on an annual basis.
Companies That Can Reduce Their Costs By Using LIFO Accounting
Utilizing LIFO might be beneficial for companies that deal in commodities whose prices go up on an annual basis. When prices are going up, an organization that implements LIFO will have a greater chance of matching its revenues to its most recent costs. A company can reduce the number of inventory write-downs they are required to conduct and save money on taxes than they would have had to pay under alternative methods of cost accounting.
The implementation of LIFO cost accounting can be beneficial to virtually any sector that is experiencing cost inflation. For instance, many groceries and pharmacies employ LIFO cost accounting since practically every product they stock faces inflation.
This is the case because LIFO accounting uses the most recently available information. Since the prices of fuel and cigarettes have grown dramatically over the years, many convenience shops, particularly those that sell both of these items, have chosen to implement the LIFO accounting method.
Oppositions to LIFO Accounting
In periods of strong inflation, those who are against LIFO argue that it skews the figures used on the balance sheet to represent inventories. They further point out that LIFO provides its users with an unfair tax benefit because it has the potential to reduce a company’s net income and, as a result, the taxes that the company must pay.
Depending on the Accounting Method, COGS Either During an Increase in Prices or a Decrease in Prices
In times of inflation, the LIFO method results in a higher COGS than the FIFO method does. This is because the things that were most recently acquired are the ones that are sold first: one hundred units from 2019, one hundred units from 2018, and fifty units from 2017.
FIFO mandates that the oldest products be sold first, starting with 100 units in 2016, followed by 100 units in 2017, and ending with 50 units in 2018. These costs are merged to make up the order for 250 units. When prices are declining, the converse is true: the cost of goods sold (COGS) is lower when LIFO is used, and it is greater when FIFO is used.
As a result, when inflation is present, the COGS determined using LIFO is a more accurate representation of the costs involved in actually replacing the inventory. Accrual accounting has a concept that is called the matching principle, and this behavior is consistent with that theory.
During times of inflation, LIFO might result in lower tax bills
The greater cost of goods sold under LIFO results in lower net earnings for One Cup, which in turn results in a reduced tax burden for the company. Because of this, LIFO is a contentious topic; some claim that it gives businesses an unfair tax holiday during periods of inflation by allowing them to deduct LIFO expenses.
In response, supporters of the proposal have asserted that any tax savings realized by the company are reinvestment and that these savings have no significant impact on the economy. In addition, supporters contend that the tax bill that a company receives when it operates under FIFO is unjust because of inflation.
Decrease Inventory Write-Downs with LIFO Accounting
The fact that there are fewer inventory write-downs required under LIFO during times of inflation is the last reason why businesses choose to utilize LIFO rather than FIFO. When it is determined that the current market price of an inventory item is lower than its carrying value, this is known as an inventory write-down.
The market cost is constricted between an upper and lower bound, which are respectively the net realizable value and then the net realizable value minus normal profit margins. The most conservative inventory values are those that are reflected by the carrying amount of the inventories on a balance sheet when inflationary circumstances are present. These are the older costs of holding the inventories. Because of this, write-downs of inventory are typically unneeded and only sometimes carried out when using the LIFO method.
Additionally, because write-downs have the potential to lower profitability and assets, solvency, profitability, and liquidity ratios can all be adversely affected. Reversals of write-downs are not permitted according to GAAP. As a direct result of this, businesses that are required to comply with GAAP have the responsibility of ensuring that every write-down is completely essential. Write-downs can have long-lasting effects.