Last In First Out (LIFO) method is one of the three widely used cost allocation formulas or methods. Although its use is prohibited under different accounting standards, but it does have advantages over other inventory valuation methods and also disadvantages. Following discussion explains some of the pros and cons of LIFO method.
1 Advantages of LIFO Valuation Method
- Most of the economies around the world are inflationary in nature. LIFO is best suited in such economies as it helps keeping cost of sales figure to closely match with the prices at the period end and thus reduce the problem of FIFO that causes cost of sales figure to be understated and ending inventory value to be overstated and ultimately leading to overstated profits.
- In case of rising prices, cost charged to units sold will be higher as compared to cost charged to ending inventory. Both of these factors will result in lesser profit figure and thus lesser tax liability. In short LIFO use enables entity do have tax savings especially under inflationary economies. This is also true for dividends. With lesser reported profits, one benefit is that entity will have to pay lesser dividend and thus keeping better liquidity position and that too without any pressure from shareholders that could have been the case under FIFO when entity will have higher reported profits and thus shareholders expecting higher dividend thus putting more pressure on entity’s finances.
- LIFO method complies with matching principle in a better way as it charges the costs with revenues from similar period unlike FIFO where units sold are charged on the basis of oldest inventory prices that may not be relevant anymore. In other words both revenue and costs are expressed in most recent currency value.
- As ending inventory values are based oldest purchased or produced units, LIFO better handles the effect of declining net realizable value especially and reduces the risks and related adjustments to record losses. If prices rose during the period but close to year end have fallen, then most probably ending inventory won’t need to be written down as newest units with high prices are already consumed and ending inventory is based on price that was prevailing before the hike.
- LIFO proves beneficial in pricing decisions especially if entity is using cost plus pricing. As cost of units sold is determined on the basis of most recent purchase cost therefore, prices determined on such costs will help recover material cost in a better way unlike FIFO where prices are based on costs that may be too low thus putting entity at risk for not recovering material costs.
- In some industries LIFO is most suited as it conforms with the actual physical flow of inventory. For example in ore extraction industry, most recently extracted material is always on top and thus always used or consumed first. However, such industries or with industries with similar circumstances are rare.
2 Disadvantages of LIFO Valuation Method
- Like FIFO, use of LIFO can get clumsy, complex and difficult to manage the inventory and respective prices of each batch if entity places many order for goods that have fluctuating price. Thus prone to more errors as well.
- Unlike FIFO it does not correspond with the normal physical flow of inventory. Usually whatever is produced/purchased first is used or consumed first. But LIFO takes the opposite approach which may not be suitable for certain industries. For example in case of perishable goods, entity will sell the oldest goods first so that old piles don’t get rotten while new batches can still have some more days of shelf life.
- Major issue with LIFO method is that it understates the value of ending inventory. This provides little to no cushion for struggling businesses as use of LIFO valuation method may seriously depress profit figures also. Thus giving no opportunity of balancing out the effect of rising expenses because of inflation.
- Inventories are valued on the basis of oldest units in the warehouse and such prices might be irrelevant and unreliable by the period end for any analysis and decision making purposes.
- Although entity may take benefits of tax savings and smaller dividend payout, but problems may outweigh the benefits in the long run. Just because of LIFO valuation, for prospective investors entity will appear under-performing and will lose to its competitors especially if others are using FIFO method to value their inventory related costs.
- Majority of regulatory authorities including IFRSs and UK GAAPs prohibit use of LIFO for general purpose financial statements. The only exception is US GAAPs which is also conforming with International Accounting Standards and future of LIFO seems grim.
- As LIFO use may render understated ending inventory and overstated cost of sales, LIFO is prohibited by majority of taxation authorities. If entity is using LIFO method then it will require separate workings and documentation for tax liability calculations. Thus costing more resources.
- Management may feel more pressure if majority of inventory is procured at the beginning of the period under inflationary economy. This will cause the management to shift its procurement activities near the end of the period so that it can have better profits. But in some cases it might be impracticable. For example nature of product is such that it is only available by January, February or it is seasonal and not available round the year. Therefore, entity will have to acquire all the units only in that limited time.