The Advantages and Disadvantages of The LIFO Accounting Method
The LIFO accounting approach is among the three commonly used formulas or strategies for expense allocation. Although certain accounting standards forbid its usage, it does offer some advantages and disadvantages over conventional inventory valuation methods. The following discussion addresses some of the LIFO accounting method’s advantages and disadvantages.
The Advantages of Using LIFO Accounting Method
- The majority of economies throughout the world are, in nature, inflationary. A LIFO accounting method is ideal in these economies because it enables the cost of sales figures to match period-end prices closely, hence avoiding the difficulty associated with FIFO, which usually results in an understated cost of sales figures and inflated ending inventory values, ultimately resulting in overstated profits.
- In the event of rising prices, the cost that is charged to the units sold would be higher than the cost of ending inventory. Both of these variables contribute to a lower profit figure and, thus, a lower tax liability. In summary, LIFO enables businesses to save money on taxes, particularly in inflationary economies. Moreover, this also applies to dividends. With lower reported profits, one advantage is that the entity would have to pay less dividend, thereby maintaining a stronger liquidity position and doing so without facing shareholder pressure. On the other hand, as would be the case under FIFO, the entity would have a higher reported income, and thus shareholders are hoping for a higher dividend, putting additional strain on the entity’s finances.
- LIFO accounting method better adheres to the matching principle since it charges expenses against revenues from similar periods, as opposed to FIFO, which charges units sold on the basis of the oldest inventory prices, which may no longer be relevant. In other words, revenue and expenses are both expressed in their latest currency value.
- Because ending inventory values are typically dependent on the most recently purchased or manufactured units, the LIFO accounting method is more effective in handling the impact of decreasing net realizable value in particular and minimizes the risks and associated modifications to record losses. If prices increased over time but then fell near the end of the year, ending inventory is not necessary to be written down anymore, as the newest units with the highest pricing have already been consumed since ending inventory depends on the price that prevailed before the hike.
- LIFO accounting method is advantageous in pricing decisions, particularly when a business uses cost-plus pricing. Due to the fact that the cost of items sold is identified on the basis of the most recent purchase cost, prices ascertained on such costs will aid in the recovery of material costs more effectively than FIFO pricing, which is based on costs that may be too low, putting the entity at risk of not recouping material costs.
- In certain industries, the LIFO accounting method is the best method since it corresponds to the actual physical movement of the inventory. For instance, the newly extracted material will always be placed on top and is consequently utilized or consumed first in the mineral extraction sector. However, these sectors or industries with comparable circumstances are pretty rare.
The Drawbacks of LIFO Accounting Method
- As with FIFO, LIFO can become cumbersome, complex, and hard to manage inventory and associated prices for each batch if an entity puts a large number of orders for commodities with shifting prices. As a result, they are prone to plenty of errors as well.
- In contrast to FIFO, it does not match an inventory’s normal physical flow. Generally, whatever is produced/bought first gets used/consumed first. However, LIFO employs the opposite method, which may be incompatible with certain sectors. For instance, in the case of perishable items, the organization should be to first sell the oldest stock to avoid rotting older stock, while new batches will have additional shelf life.
- A significant disadvantage of the LIFO accounting method is that it substantially underestimates the value of ending inventory. This gives little to or no cushion at all for struggling companies, as the LIFO accounting method may reduce the profit margins. As a result, there is no way to offset the effect of growing expenses due to inflation.
- Inventories are valued based on the oldest units in the warehouse. Such values may become irrelevant and unreliable for evaluation and decision-making purposes by the end of the period.
- While an entity may gain from tax savings and reduced dividend payouts, the downside risks may exceed the upside in the long run. Due to LIFO accounting, a company may appear to prospective investors to be underperforming. It will lose market share to competitors, especially if others utilize the FIFO approach to value its inventory-related costs.
- Most regulatory authorities ban the use of LIFO in financial statements for general purposes. Thus, the future of LIFO appears grim.
- Because LIFO may result in an undervalued ending inventory and an excessive cost of sales, the majority of taxing authorities restrict its usage. If an entity uses the LIFO accounting method, it will need separate calculations and paperwork for the tax liability. As a result, additional resources are consumed.
- Management may experience increased pressure if most of the inventory is purchased at the start of the inflationary period of the economy. This will cause management to move its procurement efforts toward the period’s end in order to maximize revenues. However, in other instances, this may be impractical. For instance, the nature of the product may dictate that it is exclusively available during the months of January and February or that it is seasonal and therefore unavailable throughout the year. As a result, the entity will be required to acquire all units within the specified time period.
Choosing between LIFO and FIFO as an inventory valuation method could significantly impact a business’s revenue, strategic planning, and tax liabilities. Its objectives and present financial situation determine the ideal method for a corporation. That is why it is recommended that you will consult the experts before choosing which accounting method will suit your company.