Various accounting procedures are adopted to reduce a company’s tax liability. The inventory valuation method is adopted by most of the companies to reduce gross profit. The Last in First out Method (LIFO) is one method used to determine the cost of goods sold in a business. More specifically, LIFO is a method of valuing inventory. A company’s business assets ready for sale are what make up the inventory. Inventory includes the raw materials, work-in-process goods, and completely finished goods. The turnover of inventory represents one of the primary sources of revenue generation. Moreover, the inventory represents the subsequent earnings of the company’s shareholders. Selling an asset for an amount more than its purchase value causes capital gain and selling for a lesser amount causes a capital loss.
LIFO is an asset-management and valuation method. In LIFO, assets produced or acquired last are used, sold or disposed of first during an accounting year. Most recently acquired assets are sold first using the LIFO method. The LIFO method is used to determine the cost of goods sold and the value of the remaining inventory.
The method is used:
- When one cannot specifically identify items of inventory; and
- Quantities of inventory were purchased at different times for different prices
LIFO removes profits arising from rises in the price level. Thus cost is accurately matched against revenue. In LIFO, the inventory is treated as a fixed asset[i]. This method seeks to eliminate from income profits that arose solely from an advance in the price level, and thus, more accurately match costs against revenues.
In order to value inventory using the LIFO method for tax purposes, the LIFO method must be used in the annual reports to stockholders and for credit purposes[ii].
When prices are rising, LIFO will produce a larger cost of goods sold and a lower closing inventory. However, in times of falling prices, LIFO will produce a smaller cost of goods sold and a higher closing inventory. In the first year in which the LIFO method is used, the cost of goods included in the opening inventory of the tax year is based on the average cost method[iii].
Moreover, where LIFO is used, the cost of goods on hand at the end of the year determined under the retail method is adjusted for price changes after the close of the preceding year. This price change adjustment is to be determined by reference to price indexes satisfactory to the IRS.
[i] 26 USCS § 472.
[ii] 26 USCS § 472.
[iii] 26 USCS § 472 (b)(3).