Last, First Out (LIFO) method is one of the three most popularly used cost allocation formulas or methods in the United States.
Although the use of LIFO accounting is prohibited under various accounting standards, there are advantages to using it over other types of inventory valuation methods.
But there are disadvantages to using it as well. This article will cover some of the pros and cons of using LIFO method in accounting.
The LIFO Method
The LIFO method in accounting is suitable in these times of rising prices (especially now that we’re going through inflation!) because the material will be supplied from the latest batch at a price that is closely related to the current price levels.
Pricing materials issued at the price of the latest available consignment will help companies fix competitive selling prices of their products.
This accounting method was first introduced in the U.S.A during the second world war. It was designed to help businesses take advantage of rising prices.
During periods of rising prices (or inflation), profit and tax liabilities under the LIFO method are lower compared to when under the FIFO method. This is because the cost will be charged at current prices that are at a higher level. You can find more about this on sourceadvisors.com.
In the same manner, in periods of falling prices, the closing stock is accosted at old prices which are at a higher level. As a result, profit and tax liability is higher.
Advantages of LIFO Valuation Method
1. It Matches Most Recent Costs against Current Revenue
The LIFO method provides companies and businesses with a better way to measure current earnings by matching their most recent costs against current revenues.
LIFO helps reduce inventory profits by matching recent costs against revenues. As a result, understatement of costs of goods sold is reduced, and profit is increased. LIFO, therefore, improves the quality and reliability of earnings.
2. Tax Benefits and Cash Flow Improvements
One of the biggest reasons why the LIFO accounting method is popular is due to its tax benefit. When businesses use LIFO during periods of inflation, the current purchases at higher prices are matched against revenues that reduce the overstatement of profit. As a result, the income tax bill is also reduced.
The income tax reduction leads to better cash flows of the company.
3. It Minimizes Write-downs to Market
When a company uses the LIFO method, its net income is less likely to feel the impact of declining prices in the future. Usually the companies that employ the LIFO method do not have a lot of inventory at current higher prices, because, with this method, they sell off the recent inventory purchased at higher price first. This means that there is little to no chances of write-downs to market in future owing to decline in inventory prices.
4. Physical Flow of Inventory
There are instances where the physical flow of inventory is equivalent to the LIFO cost flow. An example of this would be a coal pile. The most recent coal added to the pile will always be on top, therefore, the last coal in is always the first one to go out.
This is not a reason for LIFO method’s popularity because it’s quite rare to find situations where physical inventory flow corresponds to the LIFO cost flow. The first, second, and third benefits we’ve described above are the main reasons as to why this method is used by so many.
Disadvantages of the LIFO Method
The major disadvantages of using the LIFO accounting method are as follows:
5. Reduced Earnings During Inflation
The LIFO method is said to reduce earnings during inflation. A lot of companies worry that changing their accounting method to LIFO will have a negative impact on investors and will reduce their stock price because a lot of investors do not understand how LIFO and inflation affects reported earnings.
6. Inventory Understatement
The balance sheet inventory figure is usually reduced with the LIFO method because it’s based on the oldest costs. The working capital position may be a lot worse than it really is due to inventory understatement.
7. LIFO Liquidation Issues
LIFO Liquidation can increase the reported income for a specific period which results in higher tax payments for that period. In order to avoid this problem, companies purchase goods in bulk to match them against revenues. Adopting the LIFO method, therefore, causes companies to develop poor buying habits.
8. Income Manipulation
Companies using the LIFO method can easily manipulate or falsify their reported earnings for a certain time period by changing their purchase pattern at the end of the year.
How Does the LIFO Method Affect the Cost of Production?
Below are the different ways that the LIFO accounting method affects the cost of production:
- Because the prices of the latest materials purchased are used for issue purposes, the issue price is adjusted to follow the current market prices. The cost of production, therefore, reflects the current price on the market.
- The cost of production is overstated in a rising market, and the cost of production is understated in a falling market.
How Does LIFO Impact Inventory Valuation?
The value of the closing stock does not represent the current market price. This is because all the rates of the recently purchased materials are used for issue purposes. Therefore, closing stock is set at old rates but not at the current price of materials.
How Does the LIFO Method Impact Profit?
There are several ways that the LIFO method of accounting affects profit.
- The LIFO method will not affect the total profit because a price increase can be compensated by a decrease in prices over a period of time. But profits of every product or job change due to charging different rates of materials to different products.
- During inflation or a period where prices increase, higher rates of materials are charged to production. This, in turn, inflates the cost of production. As a result, a company sees a reduced margin of profit that leads to a tax deduction.
During times of inflation, companies may benefit from using LIFO accounting method over FIFO. Under LIFO can save on taxes and match their revenue better to their latest costs during inflation.