If you are running a business, you are looking for all the tax breaks that you can get. If operating within the United States, there is an inventory accounting method called LIFO that can help ease your company’s tax burden.
Having a reliable method to account for your inventory is vital for reporting your financials to stakeholders as well as having the appropriate information for your business taxes. There are three popular methods for this, and they are the FIFO, LIFO, and average cost methods.
LIFO can be defined as an inventory accounting method that expenses the most recently acquired assets first. This means that the newest assets are expensed, while the oldest assets stay on the balance sheet.
There are both drawbacks and benefits to the LIFO method:
The International Financial Reporting Standards prohibit the use of LIFO in accounting as it could be used to distort the financial position of a company. This means it is not ideal for use by businesses operating internationally, where their accounting practices would be scrutinized.
Using LIFO provides you with information on the balance sheet that is lower quality than if you used another valuation of inventory method.
With LIFO’s expensing of the latest costs, there is a greater alignment with an income statement.
Using the LIFO method in the United States can lead to businesses having a significant break in taxes.
The LIFO method is important to understand for the following reasons:
LIFO is important to understand since it lowers your profit margins and, in turn, lowers the tax liability for your organization.
Understanding LIFO is important if you are a business that intends to seek funding or credit. Since the LIFO method lowers your profit margins, your numbers might not look favorable to a lending institution.
If you use the LIFO method and sell off the newest inventory first, your customers will likely be happy to be getting products that have not been sitting in a warehouse. A customer could see it as a good indicator of quality management to get the newest product.
A manufacturing company is having to combat rising costs due to inflation. In order to help the organization’s bottom line by way of a tax break, the company’s accounting department opts to use the LIFO method for inventory management. This means that the parts that came in the day before at a higher price than the previous season will be recorded by the accountant as being sold off first. This will then show that the company has had higher costs and a net income that is lower, providing the business with a reduction in taxable income.
Here are some best practices to consider when thinking about Last in, First out (LIFO):
If you are doing business internationally, you are going to want to use the FIFO method instead of LIFO in order to comply with regulations.
If there are reasons why both FIFO and LIFO turn out to be less than ideal methods for your organization, the average cost method is an option.
LIFO is a good option to use when you are operating within the United States and you have rising inventory costs.
One thing to keep in mind if you are planning on using LIFO is that if you use LIFO in your accounting, then you will have to use the same method when reporting your financials to shareholders. Since LIFO lowers the net income, it will also bring down share earnings.
The main reason was having balance sheets that contained out-of-date information.
The FIFO method counts the oldest inventory first, while LIFO counts the newest.
FIFO, LIFO, and average cost all have the same result when there is zero inflation.
If you are wondering if LIFO is right for your organization, you need to first think about whether you are only doing business in the United States. You will also want to look at this if you are facing rising costs. Given those two criteria, you will also need to consider whether showing a lower net income will put your organization in a negative light with its shareholders. If you are solely a U.S. business facing rising costs and it will not affect your value with stakeholders, LIFO could be an appropriate inventory-costing method.