What Exactly Is the LIFO Accounting Method? Example and Definition

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LIFO Accounting is an acronym that stands for “Last-In, First-Out.” It is a relevant cost assumption approach used throughout the computation of income statements. The LIFO Accounting technique implies that even the most recently added goods to a company’s inventory were sold first. The pay rates for the most current goods were considered in the computation.

In inventory cost operations in enterprises, the LIFO Accounting approach is most commonly applied. Management has to decide on the most lucrative method often, and several inventory valuation methodologies are available. The LIFO Accounting value is based on a belief that the latest stock unit (the freshest stock) received was the first item to be used in the inventory. The LIFO Accounting approach may have many tax advantages. These advantages come as a result of the impact of the productivity of the financial statements depending on the manufacturing costs and timing of inventory movements.

Effects of LIFO Accounting Inventory Accounting

Companies have adopted LIFO Accounting as they believe that inventory costs will increase with time, which is a valid premise in times of rising prices. These companies have seen the advantages of adopting this cost assumption approach in their line of business or field. Perhaps, they deem this process compatible and fit for the area they are in. In this scenario, if you use LIFO Accounting, the costs of the most recent stock purchased are always higher than the costs of the prior acquisitions, so that the final stock value is estimated at earlier expenses, but the prices of goods sold at the latest charges are appraised. A company may reduce its claimed degree of profitability by shifting the high-priced inventory towards acquisition expenses and postpone the realization of taxable revenue.

Criticism of LIFO Accounting

LIFO Accounting critics argued that in periods of substantial inflation, it affects inventory statistics on the income statement. They further say that LIFO Accounting provides an unjustified tax benefit to its users by lowering net income and, as a result, reducing the taxes a company must pay.

Important Points to Remember About LIFO Accounting

  • LIFO Accounting (last in, first out) is a technique of inventory accounting.
  • The costs of the most recent items acquired (or generated) are expensed first under LIFO Accounting.
  • LIFO Accounting is a method of accounting that is exclusively used in the United States and is controlled by Generally Accepted Accounting Principles (GAAP).
  • When prices are rising, LIFO Accounting reduces net income while providing tax benefits.

The Benefits of Using LIFO Accounting

If the expenses of creating products or procuring inventory have been growing, the LIFO Accounting technique is utilized in the COGS (Cost of Goods Sold) computation. This may be related to inflation.

Although the LIFO Accounting approach may result in a drop in earnings, it can also lead to a reduction in the amount of corporation tax a firm must pay. If somehow the cost rises persist for a long time, the savings might be considered for a company. Thus, this process can have pros and cons, just as every method there is in the world. Like a double-edged sword, it has a setback as well as a leap offered to whoever is interested.

Why is LIFO Accounting beneficial? In principle, the cost of buying stocks will increase with time. The LIFO Accounting assessment technique strategy is based on the principle of supplying your most expensive items first. The value of unit sales shall be transferred to the sales cost section and shall be recorded as a cost for the financial statement when the income is recognized.

Example of Last In, First Out (LIFO Accounting)

  • Assume that Business A has ten widgets in total. The first five widgets arrived two days ago, each costing $100. The last five widgets were delivered the other day and cost $200 each. According to the LIFO Accounting inventory management method, the final widgets are those that have been sold. Seven widgets are purchased, and how much can the accountant record its cost?

The income is unmoved and will remain the same because each widget is priced the same in terms of sales. However, the cost or the price of the widgets is based and is determined by the method of inventory used. The last inventory is the first inventory sold, according to the LIFO Accounting technique. This indicates that the $200 widgets were the first to sell. The business went on to sell two additional $100 widgets. The overall cost of the widgets using the LIFO Accounting technique is $1,200, divided into five $200 units and two $100 units. 

As a result, during times of higher prices, LIFO Accounting generates more significant expenses and decreases net revenue, lowering taxable income. Similarly, when prices are declining, LIFO Accounting reduces expenses and raises net income, which improves earned profit.

Is LIFO Accounting Illegal?

Following the GAAP regulations, LIFO Accounting may be utilized in the United States alone (Generally Accepted Accounting Principles).

GAAP is the one that provides accounting standards. This is done for easier comparison of financial statements between companies. This implies that every company complies with the same rules. The GAPP provides guidelines for a wide range of subjects, including foreign currency assets and liabilities and income statements.

In places, specifically outside the United States, the LIFO Accounting technique is illegal. As mentioned earlier, LIFO Accounting is exclusive to the United States. Therefore places outside of the U.S Implementing or operating this scheme are unlawful. Many nations, including Russia, Canada, even India, are obligated to adopt the IFRS (International Financial Reporting Standards) Foundation’s regulations. The International Financial Reporting Standards (IFRS) offer a foundation for globally established guidelines. These guidelines are firm and are those that are followed by many countries.

Although the two sets of benchmarks differ significantly, they can be differentiated through the following short descriptive phrases. The IFRS is regarded to become more ‘principles-based,’ whilst GAAP is thought to be more ‘rules-based.’ Nevertheless, both have their unique and established characteristics to cater to the people, companies, organizations, and other groups respectively.