As a result, the company would record lower profits or net income for the period. However, the reduced profit or what’s in an auditors report earnings means the company would benefit from a lower tax liability. LIFO and FIFO are both inventory valuation methods, but they use different goods first, resulting in different implications for calculating inventory value, cost of goods sold, and taxable income. As LIFO reports higher COGS and lower net income during inflationary periods, the company’s taxable income is lower, resulting in potential tax savings.
Kristen Slavin is a CPA with 16 years of experience, specializing in accounting, bookkeeping, and tax services for small businesses. A member of the CPA Association of BC, she also holds a Master’s Degree in Business Administration from Simon Fraser University. In her spare time, Kristen enjoys camping, hiking, and road tripping with her husband and two children. The firm offers bookkeeping and accounting services for business and personal needs, as well as ERP consulting and audit assistance.
Many convenience stores—especially those that carry fuel and tobacco—elect to use LIFO because the costs of these products have risen substantially over time. The simplest valuation method is the average cost method as it assigns the same cost to each item. The average cost is found by dividing the total cost of inventory by the total count of inventory. Whether your inventory costs are changing or not, the postclosing trial balance the IRS requires you to choose a method of accounting for inventory that’s consistent year over year. Your financial statements and tax return must be consistent and use the same method.
Falling Prices
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If your inventory costs are increasing over time, using the LIFO method will mean counting the most expensive inventory first. Your Cost of Goods Sold would be higher and your net income will be lower. Your leftover inventory will be your oldest, cheapest stock, meaning a higher inventory value on your balance sheet.
If the cost of buying inventory were the same every year, it would make no difference whether a business used the LIFO or the FIFO methods. But costs do change because, for many products, the price rises every year. Advantages of LIFO include better matching of COGS with current prices during inflationary periods, which results in lower taxable income and tax savings. In the world of accounting and finance, inventory valuation plays a crucial role in determining the cost of goods sold and the overall profitability of a business. There are several methods to value inventory, including the Last In, First Out (LIFO), First In, First Out (FIFO), average cost method, and specific identification.
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One potential downside to LIFO is that it can lead to higher inventory costs as old items must be replaced frequently. Additionally, businesses may not be able to take advantage of bulk discounts since only a few items are purchased at a time. In normal times of rising prices, LIFO will produce a larger cost of goods sold and a lower closing inventory.
Comparison with Other Inventory Valuation Methods Globally
As a result, FIFO can increase net income because inventory that might be several years old–which was acquired for a lower cost–is used to value COGS. However, the higher net income means the company would have a higher tax liability. When sales are recorded using the LIFO method, the most recent items of inventory are used to value COGS and are sold first. In other words, the older inventory, which was cheaper, would be sold later. In an inflationary environment, the current COGS would be higher under LIFO because the new inventory would be more expensive.
The choice to use LIFO has been part of the U.S. tax code since its introduction in the Revenue Act of 1938. However, lawmakers have recently considered eliminating LIFO for repeal as a means to raise revenue or as a part of broader tax reform. Although LIFO can be advantageous in specific situations, it’s essential to consider its limitations under global accounting regulations.
- There are several methods to value inventory, including the Last In, First Out (LIFO), First In, First Out (FIFO), average cost method, and specific identification.
- Assuming that prices are rising, this means that inventory levels are going to be highest as the most recent goods (often the most expensive) are being kept in inventory.
- As a result, understanding LIFO and how it works is essential for business owners, managers, and accounting professionals.
- This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of LIFO, FIFO, or average cost.
- The main difference between the two methods lies in the order of expensing the inventory items.
The Bottom Line: LIFO Reduces Taxes and Helps Match Revenue With Cost
The average inventory method usually lands between the LIFO and FIFO method. For example, if LIFO results the lowest net income and the FIFO results in the highest net income, the average inventory method will usually end up between the two. Do you routinely analyze your companies, but don’t look at how they account for their inventory? For many companies, inventory represents a large, if not the largest, portion of their assets.
The average cost method takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400. LIFO, or Last In, First Out, is a common accounting method businesses can use to assign value to their inventory.
Which Is Better, LIFO or FIFO?
There are potential risks in using LIFO for inventory valuation, such as the LIFO recapture rule under Sec. 1363 (d). This is why LIFO creates higher costs and lowers net income in times of inflation. Although the ABC Company example above is fairly straightforward, the subject of inventory and whether to use LIFO, FIFO, or average cost can be complex. Knowing how to manage inventory is a critical tool for companies, small or large; as well as a major success factor for any business that holds inventory. Conversely, not knowing how to use inventory to its advantage, can prevent a company from operating efficiently.
It assumes that the newest goods are sold first, which normally increases the cost of goods sold and results in a lower taxable income for the business. Since LIFO uses the most recent, and therefore usually the more costly goods, this results in a greater expense recorded on a company’s balance sheet. This translates to a lower gross income and therefore a lower tax liability. Should the cost increases last for some time, these savings could be significant for a business.
Also, once you adopt the LIFO method, you can’t go back to FIFO unless you get approval to change from the IRS. The third table demonstrates how COGS under LIFO and FIFO changes according to whether wholesale mug prices are rising or falling. The opposite to LIFO is FIFO, which is when you assume you sell the oldest inventory first. This is the preferred method for most retailers due to the way it reflects how their operations actually work.
Under LIFO, a business records its newest products and inventory as the first items sold. The opposite method is FIFO, where the oldest inventory is recorded as the first sold. While the business may not be literally selling the newest or oldest inventory, it uses this assumption for cost accounting purposes.