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BUS103: Introduction to Financial Accounting

Last in, first out (LIFO) is only used in the United States where any of the three inventory-costing methods can be used under generally accepted accounting principles (GAAP). The International Financial Reporting Standards (IFRS), http://www.binetti.ru/bernardus/page/8?C=N%3BO%3DD which is used in most countries, forbids the use of the LIFO method. When the external stakeholders are analyzing the company’s financial health and position in the market, they mainly rely on the financial ratio analysis.

Last In, First Out (LIFO): The Inventory Cost Method Explained

As we are already aware, the LIFO reserve calculation will represent the difference between the value of closing inventory calculated using both LIFO and FIFO. However, any change in the reserve value will be due to changes occurring in the closing inventory calculated using the two methods. Explore the financial and tax impacts of FIFO vs. LIFO inventory methods and their implications on your business. The FIFO method favors a stable or deflating Economy, and the LIFO method favors an inflating economy. The LIFO reserve, however, shows a complete and total picture of a company’s finances (profits, sales, costs, revenue, etc.) in all situations.

Income Statement

By using the cost of the most recently acquired inventory to calculate COGS, LIFO can result in higher COGS during inflationary periods. This reduces gross profit and net income, which might seem less attractive to investors. However, the lower net income can be advantageous for tax purposes, as it reduces the taxable income.

• Most companies use the first in, first out (FIFO) method of accounting to record their sales.
• Most countries have prohibited the use of this accounting technique except under very special circumstances.
• At the beginning of the Year, the company’s LIFO Reserve showed a credit balance of $25000.
• The FIFO method of evaluating inventory is where the goods or services produced first are the goods or services sold first, or disposed of first.
• An instance of this is when a company uses the LIFO reserve to submit earnings to tax services when the cost of production is constantly rising but uses LIFO internally to calculate budgets and higher margins.

LIFO reserve is the difference between what the company’s ending inventory would have been under FIFO accounting and its corresponding value under LIFO accounting. Companies that use the LIFO Inventory method are required to disclose this reserve which can be used to adjust the LIFO cost of goods sold and closing Inventory to their FIFO equivalent values to make it comparable. This is why LIFO creates higher costs and lowers net income in times of inflation.

How to Calculate the LIFO Reserve

Let us study the concept of LIFO reserve calculation using LIFO reserve calculation with the help of some suitable examples. Under the LIFO reserve equation, LIFO reserve is the difference between the cost of Inventory computed using the FIFO Method and the LIFO Method. Often earnings need to be adjusted for changes in the LIFO reserve, as in adjusted EBITDA and some types of adjusted earnings per share (EPS).

This can be advantageous in times of rising prices, as the cost of goods sold (COGS) will reflect the higher recent costs, thereby reducing taxable income. However, this method can result in older inventory remaining on the books, which may not accurately represent the current market value of the inventory. The http://isha.at/index.php?option=com_content&view=article&id=720 is an account used to bridge the gap between the FIFO and LIFO methods of inventory valuation. The reserve helps to outline the many differences between the two methods and shows how each method would affect the company’s COGS (Cost of Goods Sold) in different situations. The LIFO method, on the other hand, is the Last in Last Out technique used to take inventory.

Key Differences Between FIFO and LIFO

• From this example, we can see a big difference between the two types of inventory methods.
• Adjusting for the LIFO Reserve provides a more accurate picture of a company’s profitability and financial health.
• By raising the cost, less taxable income is reported on the income statement; thus, the overall tax expense is also reduced.
• The LIFO reserve is used by a company when it calculates its inventory and cost of goods using the First in First Out method but records it under The Last in Last Out method when doing the inventory report.
• FIFO, or First-In, First-Out, assumes that the oldest inventory items are sold first.

When investors go through the LIFO reserve, they can both see how much money the company may lose on taxes, and how the actual cost of goods is affecting the inventory value and does a great job in catching an investor’s eye. In periods of deflation, LIFO creates lower costs and increases net income, which also increases taxable income. If a company uses a LIFO valuation when it files taxes, it must also use LIFO when it reports financial results to its shareholders, which lowers its net income. FIFO method better approximates the flow of cost of goods sold, so we will calculate the inventory turnover ratios by converting Company B inventories and cost of good sold to equivalent FIFO basis. Based on the example above, the difference between the two different inventory values would be $5 ($30 – $25).