Last In, First Out commonly abbreviated as LIFO is a method that many institutions use to evaluate their inventory. Using this method at the end of an operating year, one would see the inventory from the beginning of the year rather than at the end. Last in, first out inventory method aims to determine the cost of goods that businesses sell.
The most common inventory method, however, is first in, first out (FIFO). This is because it reduces the probability of remaining with obsolete stock. However, the IRS allows businesses to use LIFO if they apply via Form 970. Once one switches to the LIFO system, the IRS does not allow you to return to the FIFO inventory evaluation system. It is, therefore, essential for you to consult an accountant and a tax adviser on the most suitable system to use.
What Is Last In, First Out?
LIFO method is an inventory evaluation method that businesses apply to keep track of their stock.
- This method operates under the principle that after purchase the last inventory is leaving the first in inventory.
- In such businesses, the items that reach package last in the warehouse earn a spot at the front because the consumers select items from the front.
- The items that are first in package in the warehouse remain in the back because clients don’t order them often. Most organizations prefer FIFO to LIFO inventory. But this is because the latter may leave a large amount of the stock to be old and obsolete.
Who Needs The Last In, First Out Inventory Evaluation Method?
Organizations use last in, first out inventory accounting assuming that the value of inventory increases over time. Hence, the method is best applicable in the market economies experiencing price inflation. In such economies, the prices of the inventory last acquired are higher than the inventory first obtained.
When the highly priced inventory shift into cost of goods sold, the profits on the report will be lower. This is since the inventory balance focuses on the earlier costs. As such, LIFO method is a popular method in companies whose aim is to defer from paying income taxes.
How to Do Last In, First Out
LIFO method is in use by businesses during an inflation period where the prices of commodities are higher. Then, also the inventory profits are lower since it is recorded as cost of goods sold. The items purchased last are placed in the front shelves of a store while the items bought first are packed in the back shelves. The customers are hence expected to make their selection of goods from the front towards the back. The principle behind this is to have fast moving goods in place near the front of the store.
LIFO method of inventory accounting is also common among businesses in U.S as a way of income tax deferral. This introduces taxation inequality that may bring up issues between the commercial sector and the government.
Because of the unfair ways in which this accounting method is in use by businesses, it has been prohibited or banned according to the International Financial Reporting Standards. However, the Internal Revenue Service allows its application in organizations. The main disadvantage of using LIFO method of inventory management to businesses, however, is that goods may expire or become old hence become obsolete and hard to introduce in a market.
3 Reasons Why You Have Less Spending with LIFO Method
1. LIFO Enables the Value of Items to Increase as They Get into the Inventory
This means that if goods were purchased at $20 per item at the beginning of the year, their cost is likely to go up to about $25 especially in the case where the rate of inflation has gone up.
When businesses obtain the cost of goods sold at the end of the operating period, it shifts some of the profits hence lowering the level of profitability. If the cost of goods declines within a year, then the gross profits recorded would be higher due to the small cost of goods sold.
2. Less Taxes to Pay
Low profits mean declined income levels for a business. Consequently, this is lowering the amount of taxes that the businesses pay for the revenue have then. Low income taxes reduce on the level of spending done by an organization during its operations. LIFO method is beneficial to an organization since the cash flow is higher than when using the first in, first out inventory evaluation method. Cash flow is not taxed and since it is higher when using LIFO, it reduces on the spending made.
The FIFO method, on the other hand, has increased taxes as they record high income levels. Most businesses use it. This is because although the cash flow is low, the profits they obtain are high and appear on the financial statements. The performance of businesses is rated by the level of profits shown on the reports.
3. Paying Attention to Risks
LIFO method of inventory accounting allows businesses the opportunity to defer from paying high income taxes. However, it is not that popular as first in, first out. This is because the inventory under LIFO is hardly sold in the market. Hence, it is becoming old while in the warehouse. This in turn results in losses in a business due to profit minimization and cost maximization.
Lastly, organizations don’t always prefer LIFO because an increase in cash flow only comes from the assumption that the value of inventory increases gradually.
To Sum It Up
So you are looking to learn more about LIFO method of inventory accounting. Then, this article provides basic information on the method and highlights how different it is from first in, first out. You are now ready to pick the best method to evaluate your inventory. Focus on the benefits you obtain from it. Before picking LIFO method for your operations, however, be sure to understand its impact. Take a look at profits, cost of goods sold, and expenses with respect to income taxes. You can conduct further research on how businesses apply LIFO method.
Feel free to leave your comment on the topic for the benefit of our readers.
The images are from depositphotos.com.