Why LIFO is not permissible under IFRS?

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After the revision of IAS 2 Inventories in 2003, LIFO was explicitly prohibited to be used by the entities following International Accounting Standards to prepare and present financial statements. Before this revision LIFO was available as allowed alternative i.e. an option if company wishes to use the inventory valuation method other than the preferred method.

One of the reason that can easily be understood is that LIFO cause reduction in tax burden under inflationary economies i.e. in the times of rising prices. This happens because LIFO assumes that inventory which is bought latest will be sent to production hall to be consumed in the production process and thus higher value inventory will be included in cost of sales figure which will result in larger cost and ultimately lesser profits and thus lesser tax. So, many argue that LIFO is one of the tools to save tax “expenses”.

However, the major reason is not the impact on tax. The main reason for excluding the LIFO is because IFRSs shifted its focus on balance sheet instead of income statement which is also known as balance sheet approach. The impact of this turn in focus from income statement to statement of financial position (SoFP) requires that the figures in the SoFP should be according to present market conditions i.e. it should provide the most relevant information with respect to time and if the statement of financial position items are measured according to up to date information only then financial position can be ascertained reliably.

Now under LIFO as Last-in inventory is expensed out as cost of sales and old inventory is kept in the store therefore, the figure that will be reported in the SoFP, which will be according to the inventory in store, might be too old to be relevant for the users of financial statements. That was the main reason for abandoning the LIFO inventory valuation method as it was causing outdated information in the statement of financial position.

Remember
Statement of financial position portrays the financial position of the company at particular day thus the items of SoFP are supposed to measured according to that day to give accurate information about financial position. Whereas Incomes Statement portrays the financial performance of the entity over a period of time. Thus a trade-off was made by making SoFP more accurate by sacrificing the accuracy of accurate matching in income statement.

And this impact has its effects on more then one period as the figures of last year’s SoFP are used as opening balances for the next year accounting records. So, we can understand how serious its accounting implications were.

In USA entities are allowed to use LIFO, so if the tax would have been the reason then it would have already been prohibited there as well and also because of adoption of IFRSs in USA in place of current standards LIFO has been one of the great debate where accountants of USA are criticizing IFRSs on different grounds and are advocating current GAAPs that includes the point of LIFO where they say that LIFO provides much more realistic financial performance as matching of revenue with costs is done more accurately as cost of sales are according to market prices.

Certainly, every method has its own merits and demerits and it depends on conditions and circumstances under which a particular method is evaluated. However, as in many countries of the world the trend of economy is of inflationary nature that is why the use of LIFO provides much limited benefits and its demerits overwhelms its advantages under these economic conditions.

2 COMMENTS

  1. do you mean that as LIFO takes into account the reduction of the tax burden then the accounting standards is not allowing that as a fact that they should increase their tax expense or whats the point here?

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