The Last-In-First-Out or LIFO accounting method is the absolute opposite of the First-In-First-Out (FIFO) method (FIFO). Certain methods allow estimating the costs of products at the moment they are bought or manufactured but assign costs to goods sold on the premise that the most recently manufactured or obtained goods are sold first. Costs associated with the acquisition or manufacture of certain products are added to a pool of costs associated with the category of goods. The firm may keep FIFO expenses but monitor a counterbalance in the manner of a LIFO reserve under this approach. This LIFO reserve which can either be an asset or a contra asset account will tell the disparity between the FIFO and the LIFO cost of inventories.
The LIFO reserve is the discrepancy between the price of an inventory computed using the FIFO as well as LIFO techniques. This reserve represents the amount of taxable revenue postponed by an organization utilizing the LIFO technique.
What to Know About LIFO Reserve in Action
Assume a business currently utilizes FIFO for internal accounting but wishes to switch to LIFO for financial as well as income tax reporting by reason of the continuous rise in the prices of its cause attributed to inflation. The purpose of the LIFO reserve is to counter the inventory account that thus reflecting the gap between the LIFO and the FIFO costs of inventories.
During periods of rising expenses, the LIFO reserve fund balance will be positive, indicating that less cost is recorded in inventory. Bear in mind that under LIFO, the most recent (higher) expenses are expensed to the cost of goods sold, whilst the earlier (lower) costs are retained in inventory.
The credit amount in the LIFO reserve accounts for the difference in inventory costs between LIFO and FIFO since LIFO was implemented. The movement in the balance for the current year reflects cost inflation for the current year.
Pros in Adopting LIFO Accounting
The rise in the LIFO reserve balance will also result in an increase in the current year’s cost of goods sold, thus decreasing the company’s earnings and, consequently, its taxable income.
The change in the LIFO reserve balance for the current year multiplied by the income tax rate shall be the difference in the income tax for the year, so by slightly altering this method, one may determine the change in income tax since LIFO was implemented which is calculated as the balance in the LIFO reserve times the income tax rate.
The reporting of the LIFO reserve is preferable when comparing the earnings and ratios of a firm that uses LIFO to those of a company that uses FIFO. This is because the accounting industry has opposed the use of the term “reserve” in financial reporting, the LIFO reserve may occasionally be referred to as Revaluation to LIFO, FIFO excess above LIFO cost, or LIFO buffer.
Comparability in LIFO Accounting
If a business employs LIFO, the amount of inventory reported does not accurately represent the cost, decreasing comparability to businesses that use FIFO.
Why Is Comparability in LIFO an Important Element?
The method and collection of procedures that are being used to determine the economic worth of the owner’s stake in the business are known as business valuation. Financial market participants use valuation to establish the amount they are prepared to pay or receive in order to complete the sale of a firm. Along with determining the sales price of a firm, business appraisers frequently utilize the same valuation methods to resolve disputes concerning:
- taxation on estates and gifts;
- family law litigation;
- distributing the acquisition price of the business among its assets;
- developing a method for valuing partners’ ownership interests in buy-sell transactions; and
- a variety of other commercial and legal uses.
Inventory Valuation Using the LIFO Method
The LIFO technique leads to a decrease in ending as well as beginning inventory on a company’s balance sheet since the oldest (and hence often less costly owing to inflation) products stay in the inventory, thus with this information, one may deduce that if a business utilizes LIFO, the recorded inventory value in the company books does not accurately represent the cost of the current period. This low value has an effect on the computation and assessment of current assets, as well as any financial measures that contain inventory, reducing comparability between firms that use LIFO and those that use FIFO.
Adjustments Methods of LIFO Accounting or Normalization
- Adjustments made for comparability
The subject company’s financial statements may be adjusted by the valuer so that it will allow comparisons with other companies that are within the same industry or geographic region. These modifications are intended to reduce discrepancies between how released industry data is provided and how the relevant company’s financial statements display its data.
- Non-operating Adjustments
It is logical to suppose that if a firm were sold in a theoretical sales transaction which is the fundamental assumption of the market valuation standard, the seller would keep any assets not directly connected to earnings generation or would price these non-operating assets individually.
- Adjustments for LIFO that are non-recurring
The financial statements of the subject firm may be impacted by non-recurring events, such as the acquisition or sale of assets, litigation, or an abnormally significant revenue or cost. These non-recurring events are adjusted to ensure that the financial statements accurately represent top management’s future performance targets.
- Discretionary Adjustments
Owners of private enterprises may be compensated differently than comparable executives in the sector. To arrive at market value, the salary, perks, perquisites, and distributions of the owner must be adjusted in accordance with industry norms. Likewise, the lease paid by the relevant enterprise for the use of its owners’ personal property may be examined.
LIFO Liquidation
The process wherein a business that employs LIFO accounting systems liquidates its older LIFO inventory is known as LIFO liquidation. This occurs when current sales exceed current purchases, necessitating the liquidation of stock not sold in earlier periods.
The sum of money that firms spend on inventory typically grows over time as a result of inflation and regular pricing hikes. If a business chooses LIFO inventory management, the previous costs of inventory will indeed be aligned to the present, higher sales prices. As a result, if prices have increased since the LIFO technique was implemented, this cost carries a greater tax burden.
