When it comes to getting a clear picture of their companies’ finances, business leaders need to think beyond cash flow. Liquidity is important, especially to SMBs in their early years, but the value of a company extends far beyond its liquid assets. When preparing their financial statements either for tax purposes, external valuation, or internal review, businesses need to have a clear picture of how much of the company’s value is held as inventory.
Inventory valuation is an important part of asset management and corporate accounting. There are a number of methods that are used to gauge the value of company inventory. Last In First Out (LIFO) is one of the less commonly used methods in the US, but one that may be advantageous to some companies.
Here we’ll look at how LIFO works, how it compares to more commonly used accounting methods like the FIFO (First In First Out) method, and the pros and cons of using this system.
What is the definition of Last In First Out (LIFO)?
Last In First Out is used to calculate the value of inventory under the assumption that the most recently acquired assets will also be the first to be sold, used, or disposed of by the company. It is most commonly used by companies that have large and high-cost inventories and higher cash flows, such as car dealerships. Companies whose inventory is in constant danger of obsolescence (like consumer electronics manufacturers or retailers) may also use the LIFO method. However, it is not suitable for companies like bakeries or grocery stores where inventory is perishable and goods may be left to rot in storage if more recently acquired items sell first.
The United States is one of the only jurisdictions in which LIFO accounting can be used. The International Financial Reporting Standards (IFRS) expressly forbids the use of the LIFO method. However, in the US, the LIFO method can be used under generally accepted accounting principles (GAAP).
The LIFO method and net income
Economic conditions may be inflationary, meaning Economic conditions are usually inflationary, with the value of inventory assets increasing throughout the year. However, when using the LIFO method, lower-cost inventory purchased earlier in the year may be logged as unsold inventory, while newer inventory that is purchased at a higher cost will sell first. This in turn may lead to existing assets being undervalued. As such, the Cost of Goods Sold (COGS) will be higher and the net income is lower. This may be advantageous from a tax perspective, but the value on the balance sheet may not accurately reflect the true value of the company.
At times when inflation is static, however, net income when using LIFO accounting will have no impact on valuation when compared to other accounting methods like FIFO accounting or the average cost method.
LIFO method in practice: an example
Now we know a little about the theory of the LIFO system for inventory value calculation. But what might this look like in the real world of business?
Let’s say a used car dealership buys 10 cars of the same make and model in 2 batches of 5. Batch 1 costs $10,000 per vehicle and arrives in January while Batch 2 costs $15,000 per vehicle and arrives in February. The dealership sells 8 cars, but the in-house accounts team is unsure of how much to record as a cost.
For the sake of simplicity, we’ll assume that all 8 cars are sold at the same price, so the revenue is the same for each. However, the COGS associated with each vehicle depends on when the car was purchased. Under LIFO, we assume that the last vehicles acquired were the last vehicles sold, so all 5 of Batch 2 were sold, while 3 vehicles from Batch 1 were sold at the same price. Last-in becomes first out.
As such, the COGS is $105,000 (5 at $15,000 and 3 at $10,000) under the LIFO system. If, on the other hand, the same company carried out the exact same transaction and used the First in, First Out / FIFO system the cars costing $10,000 apiece would be sold first, followed by 3 of the vehicles that cost $15,000 each. This would change the total cost of goods sold to $95,000. A difference of $10,000.
Alternatives to LIFO
As we can see, LIFO is a fairly idiosyncratic inventory valuation method. It may be beneficial for some companies under the right circumstances, but it is usually eschewed in favor of the following:
First in First Out (FIFO) system
The FIFO inventory method is the most commonly used accounting system and often represents the flow of inventory through a company more accurately than LIFO. Here, inventory items bought, made, or acquired first are also the first to be sold.
Average cost method
Under the average cost inventory valuation method, every item of inventory is assigned the same cost, regardless of when it was acquired. An average cost is calculated by dividing the cost of goods in inventory by the number of sale-ready items.
LIFO pros and cons
In order to determine whether LIFO accounting is the best fit for your operations, it’s essential to look at its advantages and disadvantages in comparison to other inventory valuation methods.
Let’s take a look:
LIFO method advantages
may result in a lower tax liability due to higher COGS and lower balance of leftover inventory
often advantageous to businesses that use the cash accounting method
permissible in the US under GAAP standards
fewer inventory write-downs
LIFO method disadvantages
more complex and less intuitive than alternatives like FIFO
older items in inventory can cause COGS to fluctuate
lower reported income and net worth may discourage investors
not permissible under IFRS
LIFO vs FIFO: Which is better for your small business?
As we can see, LIFO is an accounting tool that may be apt to use for particular businesses or under specific circumstances. While FIFO is a good all-rounder when it comes to inventory management, there may be some circumstances where LIFO is a better fit for your operations.
For instance, it may be a good fit:
when costs have risen steeply in a short space of time
for businesses with non-perishable inventory
for businesses whose tax liability would be unfairly high under FIFO accounting
While LIFO is a rarely used asset management and valuation method, if any of the above apply to your business, it may well be the right one for you.