What is the LIFO Inventory Method in Accounting?
LIFO (Last In First Out Method) is one of the methods of accounting of inventory value on the balance sheet. Other methods are FIFO inventory (First In First Out) and Average Cost Method.
LIFO Accounting means Inventory, which was acquired last, would be used up or sold first. This implies that the cost of goods sold would include the cost of Inventory that was acquired recently. And the cost of Inventory remaining, as reported in the balance sheet, would be the cost of the oldest inventory remaining.
Inventory forms a part of Current Assets in the balance sheet. It can be taken as collateral for loan/ working capital purposes. Hence it is necessary to have a measure of the value of Inventory on the balance sheet. The amount of Inventory purchased determines the cost of goods sold (COGS), which in turn determine the profitability and tax liability.
Due to the above two main reasons, it is necessary to have a method to arrive at the value of Inventory. Now, this is where LIFO accounting, FIFO and Average Cost Method come into the picture. Companies have to make disclosure in their financial statement about which method they are adopting for Inventory Valuation.
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LIFO Method Example
In this LIFO method example, consider a case of M/s ABC Bricks Ltd, a distributor of cement bricks. It receives stock of bricks from the manufacturer on a daily basis; however, the prices keep changing on a daily basis. The company receives orders from customers on a weekly basis.
The details of stock purchases are as follows:
On day 1 of the week, the company purchased 20 bricks for Rs. 25 per piece. This price increased to Rs. 35 per piece by the end of the week due to strong demand in the market.
Now on the 6th day, the company also receives an order of 50 bricks at a selling price of Rs 36 per piece. Assuming the company is following the LIFO method of inventory accounting, the purchase value of these 50 bricks being sold can be calculated as follows:
LIFO Accounting – Profit & Loss Calculations
Rs. 1710/- would be reported as COGS in Profit & Loss statement. There would be a profit of Rs 90/- (50 bricks x Rs 36 – Rs 1710/-) in this transaction, and tax liability on profit would be Rs 27/- considering the flat tax rate of 30%.
LIFO Accounting – Balance Sheet Calculations
The remaining Inventory reported on the balance sheet would be at their actual original cost of purchase. Thus the inventory value can be calculated as follows:
Impact Due to LIFO Method Example
- Due to the LIFO method of Inventory, COGS came out to be Rs 1710/- resulting in only Rs 90/- as profit. Since we considered purchase cost as that of last Inventory which was purchased, our COGS remained higher, ensuring lower profit and thereby lower tax outgo. Thus in inflationary conditions, LIFO Accounting (Last In First Out method) results in lower tax outgo.
- Since profit is on the lower side, the earning per share would be on the lower side. Thus in inflationary conditions, LIFO Accounting (Last In First Out Method) results in lower EPS.
- The value of the Inventory remaining is Rs. 5320/- which is lower since it is valued at the purchase price of that particular batch of bricks. Due to the LIFO method of Inventory, the value of the remaining Inventory is considered lower than the present market value/ replacement value of that Inventory. Thus in inflationary conditions, the LIFO method results in a lower valuation of stock on the Balance sheet than extent replacement value.
What is the Case in Deflationary Market Conditions?
In the deflationary market scenario, LIFO Accounting (Last In First Out Method) results in exactly reverse of above. Viz:
- Higher tax outgo as COGS is reported lower and profits are higher.
- Due to higher reported profits, EPS would be higher.
- The Inventory would be valued more than the current market value/ replacement value resulting in inflating the balance sheet.
LIFO Method Advantages and Disadvantages
- In an inflationary market, the use of LIFO methods results in higher COGS as Inventory is valued at recent prices. This results in lower net income and thereby lower tax liability for the company. However, due to lower net income, the company’s reserves & surplus remain lower than what it would have been if LIFO (Last In First Out method) was not used. This results in lower net worth and lower EPS for shareholders.
- In the deflationary market, the use of LIFO (Last In First Out Method) results in lower COGS as Inventory is valued at recent prices. This results in higher net income and higher tax liability for the company. However, due to higher net income, the company’s reserves & surplus remain higher than what it would have been if LIFO (Last In First Out Method) was not used. This results in higher net worth and higher EPS for the shareholder.
Thus, the LIFO method of Inventory has both its benefits and drawbacks. Management has to weigh both and decide whether to use the LIFO method for Inventory valuation or not as per business needs.
Global Treatment of LIFO Method of Inventory
- IFRS, which is followed in most of the countries, does not allow LIFO accounting.
- US GAAP allows the LIFO method of Inventory.
- In India, as per Revised AS 2, the LIFO method of Inventory is not permitted, and companies would have to account Inventory based on either FIFO or weighted average cost method.
LIFO Inventory Method Video
Significance for Investors
Investors should scrutinize accounting policies disclosed by the company and trend in change in accounting policies before making any decisions. Use of LIFO Accounting (Last In First Out Method) or FIFO or Average cost method has wide implications on the P&L and Balance sheet, as shown above.