Inventory decisions are not only operational but also strategic. LIFO or Last In First Out is a method that companies use to manage and value inventory by assuming the newest stock is sold first. While the concept is simple, the implications for cost control, tax strategies, and financial reporting are not.
It can offer tactical advantages for companies facing rising material costs or seasonal fluctuations. This article outlines how it works, why it matters, and how your business can decide if it is right for you.
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Key Takeaways
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What is LIFO?
LIFO stands for Last In First Out and is a method companies use to account for inventory. It assumes that the newest items added to stock rotation are sold or used first while older items remain in storage.
This approach is often used when prices rise because it accurately reflects recent costs in financial reporting. While it doesn’t follow the actual movement of goods it can help businesses manage taxes and margins more effectively.
How the LIFO Method Works
The LIFO method assumes that the most recently purchased or produced items are sold or used first. When a company sells goods or uses inventory, it records the cost of the most recently acquired items as the cost of goods sold (COGS).
The older inventory remains on the balance sheet at its original cost. For example, imagine a company buys raw materials at ₱500 per unit and later purchases the same materials at ₱600 per unit. Under its method, the company will first sell the units purchased at ₱600.
The remaining inventory will be valued at ₱500 per unit. When used within a perpetual inventory system, this method allows businesses to continuously track inventory movements in real time, ensuring that cost and stock data remain accurate.
This approach helps align the cost of goods sold with current market prices, which can be beneficial for managing profit margins and taxes, particularly during periods of inflation.
The Key Differences Between LIFO and FIFO
Understanding the key differences between LIFO and FIFO is crucial for businesses to make informed inventory control, taxation, and financial reporting decisions. Let’s break down how each method affects your company’s financials with a quick comparison.
| Aspect | LIFO | FIFO |
| Inventory Valuation | Assumes the newest inventory is sold first. | Assumes the oldest inventory is sold first. |
| Cost of Goods Sold (COGS) | Higher COGS during inflation due to recent higher costs. | Lower COGS during inflation, as older, cheaper inventory is sold first. |
| Tax Implication | It may reduce tax liabilities in inflationary times. | Higher tax liabilities due to higher reported profits. |
The Advantages and Disadvantages of Using LIFO
LIFO can be a powerful tool for inventory management, but like any method, it comes with benefits and challenges. Understanding these pros and cons will help you determine if it is the right choice for your business.
Advantages of LIFO
- Tax savings during inflation: Using the most recent, higher-cost items for sales, LIFO results in a higher cost of goods sold (COGS) and lower taxable income, which can lead to tax savings, especially during periods of inflation.
- Improved cash flow: Lower tax liabilities mean more cash flow for the business. With its companies, they can keep more earnings for reinvestment or to cover operational costs.
- Better alignment with current market prices: LIFO reflects the most current market conditions by valuing the most recently purchased inventory. This approach provides a clearer picture of profitability, especially in industries with fluctuating prices.
Disadvantages of LIFO
- Lower inventory value: Since LIFO sells the most recently acquired inventory first, the remaining inventory is valued at older, lower costs, which can underestimate the actual value of your assets.
- Not accepted in all countries: It is not allowed under specific accounting standards, such as the International Financial Reporting Standards (IFRS), which means it may not be a viable option for global businesses.
- Can lead to inaccurate profit reporting: It may not accurately reflect the physical flow of goods, potentially distorting profit margins. In stable or declining prices, it may overstate costs and understate profits.
- Complicated for financial reporting: It can make financial reporting more complex, as businesses may need to maintain separate inventory records for tax and financial reporting purposes.
Is LIFO an Illegal Practice Under Global Accounting Standards?
Although LIFO is not illegal, it is not permitted under the International Financial Reporting Standards (IFRS), which are adopted by many countries worldwide. In contrast, the United States allows using LIFO under its Generally Accepted Accounting Principles (GAAP).
While the method remains legally valid in jurisdictions that recognize GAAP, it is considered non-compliant under IFRS.
As a result, companies operating in international markets must carefully assess their reporting requirements and regulatory environment before adopting LIFO as an inventory valuation method.
Why is LIFO Banned by IFRS?
LIFO is banned under IFRS because it usually does not accurately reflect a company’s current inventory value or financial position. It can significantly understate the value of remaining inventory on the balance sheet by assigning the latest and often highest costs to the cost of goods sold.
This can lead to inconsistencies in financial reporting and make it harder for investors and regulators to compare companies across borders.
IFRS favors methods like FIFO or weighted average because they offer more transparency and consistency, especially in a global context where comparability is essential.
Conclusion
LIFO offers specific advantages for companies that operate in inflationary environments or industries with frequent cost changes. While it’s not accepted under IFRS, LIFO remains a strategic option under U.S. GAAP, helping businesses reduce taxable income and better align their cost reporting with recent market prices.
Choosing the proper inventory method depends on your business model, compliance needs, and long-term goals. With the right system, managing LIFO becomes far more efficient and accurate.
HashMicro’s cloud-based inventory solution is designed to support multiple costing methods including LIFO, helping businesses streamline operations and make informed financial decisions. If you’re exploring better ways to handle inventory, request a free demo to see how the platform can adapt to your unique needs.
FAQ LIFO
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Is LIFO good or bad?
Although LIFO provides a more accurate picture of your current inventory costs, it doesn’t match up well with the physical flow of goods. In other words, the items you purchased most recently are not always the items you sell first. As a result, LIFO can lead to supply shortages and lost sales.
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Is LIFO better for inflation?
By reducing taxable income, LIFO allows businesses to retain more cash. This is particularly helpful in inflationary markets, as it provides companies with additional capital that can be used for investment, debt or other everyday operational needs.
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What is the effect of LIFO?
Assuming that prices tend to rise over an accounting period, the LIFO method results in a lower value for the cost of goods sold (COGS), resulting in a lower tax liability at the end of the accounting period. It may also be easier to implement if recently-purchased inventory is more accessible.
