LIFO method assumes that the last items acquired are the first items sold, therefore cost of goods sold is based on most recent costs incurred, it is used to reflect current costs and minimize inflation impact on cost of goods sold and ending inventory value. – Definepedia
Effects of LIFO Inventory Accounting
The LIFO inventory accounting method is use by companies to manage their inventory costs. The assumption behind this method is that the cost of inventory increases over time, which is a common occurrence in inflationary environments. By using LIFO, companies can ensure that the most recent inventory they acquired is value at a higher cost than the older inventory.
This results in the older inventory being reporte as the ending inventory balance. while the most recent and higher-cost inventory is report as the cost of goods sold. This can help a company reduce its report level of profitability and delay the recognition of income taxes. So the main benefit of using LIFO is the deferral of income taxes. Which is why it is not allowed under international financial reporting standards. But it is still permitted in the US with the approval of the Internal Revenue Service.
- LIFO (Last In, First Out) inventory accounting method results in a lower cost of goods sold and higher taxable income in times of rising prices.
- The LIFO method can also lead to larger inventory valuation differences between the financial statements and tax returns.
- It can also result in a mismatch between the physical flow of goods. and it recorded cost of goods sold, leading to potential inaccuracies in financial statements.
- It may not reflect the current market value of inventory and can result in overvaluation of ending inventory.
- it can make it difficult for companies to compare their performance to their competitors. As different companies may use different inventory methods.
- it is not acceptable for companies that have to report their financials under IFRS ( International Financial Reporting Standards). And companies have to adopt FIFO (First In First Out) method.
Alternative Costing Methods
There are other ways to account for inventory costs that can be use instead of LIFO. One of them is the FIFO method, which stands for First-In-First-Out. This method assumes that the oldest items in inventory are use or sold first, so only the newest items are left in stock.
Another option is the weighted average method. This method calculates the average cost for all the items currently in stock. Rather than assigning a specific cost to each individual item. So both of these methods can be more realistic in certain situations. And it can provide a more accurate picture of inventory costs.
Example of LIFO
|Operation (Purchase/ Sell)||Stocks in Store|
|Purchase||apple, banana, cherry|
In this example, we are using a table to represent a stack data structure. The stack is empty, and we perform three products to add the “apple”, “banana”, and “cherry” to the stock. We then perform two Sell, which remove the most recently added items “cherry” and “banana” from the stock. The final state of the stack is “apple”, which shows the LIFO.