Inventory accounting is a vital process for businesses that manage physical goods, as it determines how costs are assigned to sold items and remaining stock. The Last-In, First-Out (LIFO) accounting method assumes that the latest inventory added to stock is sold first, which can significantly impact financial results and tax liabilities.
Under LIFO, the Cost of Goods Sold (COGS) reflects the cost of recent purchases, while ending inventory consists of older costs. For example, if a bakery buys 100 loaves at $2 and then 150 loaves at $2.50, selling 120 loaves means 100 loaves are costed at $2.50 and 20 loaves at $2. This results in higher COGS when prices increase, lowering reported profits and taxable income.
This method is especially advantageous during inflation because it matches higher recent costs against revenues, reducing taxable profits. However, if inventory decreases significantly, LIFO liquidation can cause older, cheaper inventory costs to increase taxable income.
Businesses in industries like oil, manufacturing, and wholesale often use LIFO to manage tax obligations. The IRS requires that if LIFO is used for taxes, it must also be applied in financial reporting, known as the LIFO conformity rule.
While LIFO can offer tax benefits, it complicates inventory valuation and is not allowed under International Financial Reporting Standards (IFRS). Companies must carefully track inventory layers and consult tax professionals to navigate LIFO’s nuances.
For detailed information on related inventory accounting terms like Cost of Goods Sold (COGS), visit FinHelp.io’s glossary page on Cost of Goods Sold (COGS).
Key Points About LIFO:
- Assumes newest items are sold first, older inventory remains.
- Raises COGS during inflation, reducing taxable income.
- LIFO liquidation can trigger higher taxes if inventory drops.
- Requires consistent use for tax and financial reporting (LIFO conformity rule).
- Common in U.S. industries but prohibited under IFRS.
Real-World Example:
An oil refinery using LIFO during rising crude prices reports higher COGS and lower income taxes, aligning expenses with current market costs.
Considerations for Businesses:
- Monitor inventory to avoid unexpected LIFO liquidations.
- Evaluate if LIFO matches your price environment and financial goals.
- Ensure compliance with IRS rules and financial reporting standards.
- Consult tax advisors to manage LIFO’s complexities.
For official guidance, refer to IRS resources and consult the latest tax publications to align your accounting practices with regulations. Using LIFO strategically requires a thorough understanding of its financial and tax implications.