The Impact Of LIFO Accounting Method Of Valuation And How It Differs From FIFO

The LIFO accounting method or the last in first out method has been one of the methods used to value inventories of businesses. The LIFO accounting method assumes that the goods that have been produced or purchased last are sold first by the business entity, and the items that have been produced or purchased first are assumed to be retained idle in the storage.

To explain this a bit further, there are 3 costing methods of inventory. These are the LIFO accounting method, FIFO or first in first out and the weighted average methods. The last in, first-out or LIFO accounting method is based on the assumption that items or goods purchased last are the ones that should be sold first by the business. The LIFO accounting method of valuation is often most utilized by companies with a fairly large level of inventories such as retailers. And LIFO accounting is used to take the tax benefit by including the costs of items purchased or produced recently at a much higher cost in the rate of goods sold. In some countries, LIFO accounting of valuation is unallowed to be utilized.

LIFO Accounting Inventory Valuation Impacts

If the LIFO accounting method is utilized, it could mean that the products purchased first remain in the store and become very old and worst, obsolete. The valuation under the LIFO accounting method as well makes the inventory valuation very low such that the cost of old items in the inventory is less than the price of those new items produced or purchased (that have been subjected to the inflating market).

The LIFO accounting method therefore cannot be considered as realistic in today’s setup because it demonstrates that the older inventory remains idle in storage and only the new items are sold. The LIFO accounting method further demonstrates an incorrect valuation inventory and a very low turnout.

When LIFO Accounting Method Can Be Most Applicable

As mentioned above, the LIFO accounting method of valuation is often utilized by business entities with relatively large levels of inventories. Examples of these entities are retailers. They often turn to the LIFO accounting method to take the tax benefit due to the time of inflation cause the cost of production or purchasing to increase. The inventory of earlier items is at obviously low costs, and the high costs of recent inventories are taken into account in the calculation of the prices of goods sold. As a result, sale prices are matched with higher prices to calculate business profits, in doing so it decreases the profits of the business, translating to favorable results in lowering income tax contributions.

How Does LIFO Accounting Method Differ from FIFO Inventory

The differences between the LIFO accounting method and the FIFO accounting method can be summarized as follows:

• A LIFO accounting method is based on the assumption that inventory items purchased first by the business entity are sold first while the FIFO or first in first out method of inventory valuation is based on the assumption that the items produced or purchased first are sold first by the business.
• Utilizing the FIFO accounting method shows that the value of closing inventory is more, and the prices of goods sold are less when compared to the value of closing inventory and the prices of goods sold as valued by the LIFO accounting method. This is what happens because, under the FIFO accounting method, the value of goods inventory includes the prices of item costs of those that have been recently purchased, thus the cost of goods includes the cost incurred for old items and it has incremented now due to inflation which makes the costs of recently produced items more than the costs of products purchased earlier.
• Comparing both, the FIFO accounting method has been considered the more logical and realistic method than the LIFO accounting method because the FIFO method prevents old inventory items to remain idle in the store.

What Advantages Does the LIFO Accounting Method Offer Businesses

Although quite unpopular in some countries, the LIFO accounting methods offer benefits as well. Here are some advantages that the LIFO accounting method offers businesses as follows:

• The LIFO accounting method is simple to implement and comprehend.
• The LIFO accounting method provides business entities tax benefits by reporting fewer profits thereby deferring income tax payments in the succeeding years.
• The LIFO accounting method of valuation matches the current cost with the current revenues of the business entity resulting in reduced profits included in the inventory.

What Disadvantages Does the LIFO Accounting Method Have

As in any method, the LIFO accounting inventory valuation has its disadvantages as follows:

• At the point of inflation, the LIFO accounting method results hide the actual profits of the business entity and can result in a negative impact on the profitability position of the business on the part of the investors.
• The inventory figure for the LIFO accounting method is understated at the point of inflation as the inventory includes costs for products earlier produced or purchased and the cost of older products is expected to be less than the newly purchased items.

• The LIFO accounting method becomes more complex when the costs of items keep fluctuating.

Is LIFO Accounting Method the Best Inventory Valuation Method for Business?

It depends on the kind of business dealings an entity has. For businesses with several inventory levels, they can preferably opt for the LIFO accounting method. Examples of businesses that can optimize the use of the LIFO accounting method are supermarkets, convenience stores, drug stores, automobile dealers, automobile parts stores, heavy trucks and trailers, construction equipment, farm equipment stores, and wine or liquor stores. LIFO accounting method can also be the best valuation method to determine current assets for dollar stores, sporting goods stores, apparel stores, electronic stores, furniture stores, and food and grocery retail distribution.

On the other hand, if a business is small or if it deals with perishable goods like vegetables and fruits and goods for exportation, the FIFO accounting method is more feasible because of the reverse order. Taking the example of the perishable products, all the items come with expiration dates and even sooner than non-perishable goods, therefore logically, older ones should be sold out first to reduce wasted products and archaic inventories.