LIFO method

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LIFO is one of the methods of accounting for inventory and its disposal. It can be used for the valuation of both goods and products as well as materials. In general, this technique assumes that the newest iteam entering warehouse is going to be used or sold first. Therefore, the abbreviation LIFO comes from English phrase Last-In, First-Out[1].

LIFO vs. FIFO

The opposite method to the LIFO is FIFO (First-In, First-Out). Intuitionally, the valuation of inventory under FIFO is carried out on the basis of assumption connected with the chronological flow of costs. It is based on the idea of posting expenditures, starting with the item that was first received in the warehouse. This concept stands in total contradiction to LIFO method that works the other way round. Nonetheless, it is specially useful in case of goods that are perishable in nature. With handling first the earliest stock, the risk of obsolescence diminishes. What is more, it is most commonly used in maintaining inventory of companies of different kind as well as being regarded as the most logical. At this point it is also worth to mention another leading difference of those two concepts, mainly their applicability. It should be underlined that International Financial Reporting Standards prohibit the use of the LIFO method. Therefore, only entities falling under the jurisdiction of U.S. generally accepted accounting principles (GAAP) may apply it[2].

Reasons for using LIFO

There is no one best method of inventory valuation – each of them is suitable under specific circumstances. In general, inventory valuation is an important aspect in any business as prices constantly fluctuate. For that reason, each entity is responsible for ensuring the transparency of its financial statements by adopting specific accounting standards and, consequently, inventory valuation method. As a result, there are no instances where the accounted price can be manually selected when selling the final goods. Although LIFO is prohibited by IFRS, there still exist some advantages claimed for LIFO over FIFO. It is believed that due to its nature it provides the best matching of current costs with current revenues than any other metod. What is more, it is also counter-cyclical. During periods of boom connected with inflation, it allows companies to post lower profits than under the FIFO method, therefore incurring so-called tax opportunities. LIFO is usually more preferable from the standpoint of the difference in tax payments, but it is managers responsibility to choose in trade-off, if high reported profits or tax advantages outweigh. On the other hand, with the LIFO method, there is also a risk that in the case of inventories that are always kept at a certain safe level in a given enterprise and are never spent to zero, the inventory will be valued at prices at which it was accepted even many years ago. That may result in reduction of value of inventory in the balance sheet[3].

Example of application

The production company ABC buys material X necessary to be used in the production process. For the valuation of its inventory the company ABC uses LIFO method. In April, company ABC bought 20kg of material X for 45€, in May another 20kg this time for 55€ whereas in June it was decided to buy 45kg as the price fell to 40€. On the other hand, in July the same company managed to process under manufacturing operations 70kg of material X. What was the cost of material X consumption in the production process?

Data:

Purchase month Quantity (kg) Price (per kg) Value
April 20 45€ 20*45€=900€
May 20 55€ 20*55€=1100€
June 45 40€ 45*40€=1800€

Solution:

  • Consumption cost of material X reported in July: 45*40€+20*55€+5*45€ = 3125€
  • In inventory of company ABC remained 15kg of material X with reported value of: 15*45€ = 675€

Footnotes

  1. E. A. Helfert (2001), Financial Analysis Tools and Techniques: A Guide for Managers, Published by McGraw Hill Professional, p. 140-141
  2. M. Y. Khan, P. K. Jain (2010), Management Accounting, Published by Tata McGraw-Hill Education, p. 825
  3. S. Henderson, G. Peirson, K. Herbohn, B. Howieson (2015), Issues in Financial Accounting, Published by Pearson Higher Education AU, p. 160

References

Author: Paulina Załubska