The LIFO method is used in the COGS (Cost of Goods Sold) calculation when the costs of producing a product or acquiring inventory has been increasing. This may be due to inflation.
Although the LIFO accounting method may mean a decrease in profits for a business, it can also mean less corporate tax a company has to pay. Should the cost increases last for some time, then these savings could be significant for a business.
What Is a LIFO Example?
Here is an example of a business using the LIFO method in its accounting.
Brad runs a small bookstore in Boston’s airport called Brad’s Books. He has two partners but they do not oversee the day-to-day operations, they are merely investors. Brad does most of the work and has been in business for two months.
Brad prides himself on always making sure his store carries the latest hardcover releases, because traditionally sales of them have been reported as very good. However, the book industry has been going through a hard time recently with an increase in customers switching to digital readers, meaning less demand. As such, his inventory costs have been steadily increasing.
Here is what it’s been costing Brad to build up his inventory:
On Dec 31, Brad looks through the store sales and realizes that Brad’s Books has sold 450 books to-date. Brad would now like to run a report for his partners that shows the cost of goods sold.
Using the LIFO method, Brad would start with his most recent per book cost of $20.00. However, he cannot apply that unit price to all 600 books, because he did not pay that price for all 600. What he can do is this:
Cost of Goods Sold Calculation
150 books x $20.00:
$3,000.00 (using Dec 15 cost)
150 books x $19.25:
$2887.50 (using Dec 7 cost)
150 books x $18.50:
$2775.00 (using Dec 4 cost)
COGS Total: $8662.50
The 450 books are now no longer considered inventory, they are considered cost of goods sold. The value of the remaining books will stay in inventory.
The LIFO method assumes that Brad is selling off his most recent inventory first. Since customers expect new novels to be circulated onto Brad’s store shelves regularly, then it is likely that Brad has been doing exactly that. In fact, the oldest books may stay in inventory forever, never circulated. This is a common problem with the LIFO method once a business starts using it, in that the older inventory never gets onto shelves and sold. Depending on the business, the older products may eventually become outdated or obsolete.
Under LIFO, using the most recent (and more expensive) costs first will reduce the company’s profit but decrease Brad’s Books’ income taxes.
Is LIFO Illegal?
LIFO is permitted to be used only in the United States, under rules set out by GAAP (Generally Accepted Accounting Principles).
GAAP sets accounting standards so that financial statements can be easily compared from company to company. This means all companies follow the same set of rules. GAPP sets standards for a wide array of topics, from assets and liabilities to foreign currency and financial statement presentation.
The LIFO method is prohibited outside the United States. Many countries, such as Canada, India and Russia are required to follow the rules set down by the IFRS (International Financial Reporting Standards) Foundation. The IFRS provides a framework for globally accepted accounting standards.
Although there are many differences between the two sets of standards, the IFRS is considered to be more ‘principles-based’, while GAAP is thought to be more ‘rules-based’.
What Is Difference Between LIFO and FIFO?
LIFO stands for “Last-In, First-Out”.
FIFO stands for “First-In, First-Out”.
The LIFO method goes on the assumption that the most recent products in a company’s inventory have been sold first, and uses those costs in the COGS (Cost of Goods Sold) calculation.
The FIFO method does the opposite - it assumes that the oldest products in a company’s inventory have been sold first, and uses those lower cost numbers instead.
Why Is LIFO Better Than FIFO?
It may not be. It really depends on market conditions.
The LIFO method is attractive for American businesses because it can give a tax break to companies that are seeing the price of purchasing products or manufacturing them increase. However, under the LIFO system, bookkeeping is far more complex, partially in part because older products may technically never leave inventory. That inventory value, as production costs rise, will also be understated.
As well, the LIFO method may not actually represent the true cost a company paid for its product. This is because the LIFO method is not actually linked to the tracking of physical inventory, just inventory totals. So technically a business can sell older products but use the recent prices of acquiring or manufacturing them in the COGS (Cost Of Goods Sold) equation. This means the COGS number that is generated is not accurate.
For these reasons, the LIFO method is controversial and considered untrustworthy by many authorities. This is why it is banned as an accounting practice outside the United States.
The FIFO method is more trusted because when a company sells off older products first, and accounts for it that way, the resulting costs gives a more accurate picture of a company’s finances, including the value of current inventory. This information helps a company plan for the future.
What Is LIFO Reserve?
The LIFO reserve is the amount by which a company’s taxable income has been deferred, as compared to the FIFO method. This is because when using the LIFO method, a business realizes smaller profits and pays less taxes.