Keeping a check on your inventory and the prices at which the raw materials were bought and the prices at which they need to be sold is a very important job. Three different inventory accounting practices are followed worldwide, and today in this article, we will cover the information about LIFO. Last In First Out, LIFO is an inventory accounting management system that is quite famous in the west but not as much as in India. The other two inventory accounting practices are FIFO which is First In First Out and Weighted Average, which is more common in India.
While using the Last In First Out system isn’t allowed in India due to a few accounting discrepancies which we will address in the latter part of the article, it is important to know the method of LIFO, how it is different from First In First Out, FIFO and weighted average. Having knowledge about all the inventory accounting practices is important as it keeps you more informed and educated and helps you make better decisions regarding your business and accounting systems.
What is LIFO and how is the method calculated?
Last In First Out is an inventory management system used in businesses to keep a check on the existing inventory, how the selling of goods has worked, and represent the figures on the balance sheet and profit and loss statement. Last In First Out is the full form of LIFO and it is very easy to follow and adapt in the business. However, sometimes following LIFO can have a misrepresentation of the final figures on the balance sheet and profit & loss statement, which is why this method isn’t widely used.
The way Last In First Out, LIFO work is that the products that have come in the inventory the latest are the first ones to be sold off first and the prices are the latest prices of the newest inventory that reflect on the balance sheet and profit & loss. But due to the following Last In First Out, LIFO, many times the old stock remains unsold for months, leading to more inventory and dead stock. Also with times and trends changing if the earlier stock is not cleared and new stock is sold out first, a big sum of cash will be stuck in the old inventory.
Another point to note is that during a period of rising prices, as the newer goods are sold first, the higher prices reflect on the balance sheet and profit & loss statement, which inflates the balance sheet and understates the profit. This isn’t a true representation of the actual inventory as there is the old inventory that is yet to be sold and currently is just lying around as dead stock. This is the reason why many companies do not wish to follow the Last In First Out inventory accounting practices and this is why it isn’t allowed in India too. However, it is still an accounting practice that does come with its own set of advantages and benefits that need to be spoken of.
What are the advantages of the Last In First Out, LIFO method?
While First In First Out, FIFO is more preferred as an inventory management system, Last In First Out, LIFO also comes with its own sets of advantages and pros that could benefit the business. Some of the advantages of Last In First Out, LIFO are:
- Updated Numbers: Since Last In First Out, LIFO sells the latest goods first, the prices are the latest prices that reflect on the balance sheet and profit & loss statement. This also reflects the latest balances of the business and the cash flow of the business.
- Latest Inventory: Since the goods and inventory sold are the latest products, the sellers tend to sell stuff that is completely in fashion and trend. This tends to increase the sales of the business and it also helps in gaining popularity for the business.
- Improvement in Cash Flow: Many times a business is stagnant as they cannot sell the old stock of inventory which is why there is no inflow and outflow of money. With Last In First Out, LIFO and following this inventory accounting practice, the latest goods are put on display first and this leads to a movement in cash flow, ensuring goods are rolled in and out quicker than expected. Due to this, there is an improvement in the cash flow because of following the Last In First Out system.
- Tax Benefits: One of the biggest advantages of the Last In First Out, LIFO method is the tax benefits businesses and enterprises receive because of the selling of inventory. During the periods of rising prices and thus in turn of a period of inflation higher prices are paid for the goods and stock which in turn is compensated by higher revenues, which leads to a lower net income and hence the tax paid is also lower. Due to lower net income, and lower tax paid, the cash in the business is higher and hence it also helps improve the cash flow. The biggest reason a company may use Last In First Out is the tax advantage it has compared to the First In First Out method.
Disadvantages of Last In First Out
While Last In First Out may seem like a great option to follow for the inventory accounting methods, there are quite a few disadvantages that come along with it. Due to the disadvantages being more than the advantages, many countries globally have decided not to use the Last In First Out system for better accounting practices. India is one such country that does not allow the Last In First Out, LIFO method for inventory accounting practices.
Some of the disadvantages of Last In First Out, LIFO are:
- Reduced earrings and Net Income: While lower net income helps in tax benefits and in turn improves the cash flow, the overall profit of the company reduces during periods of rising prices and inflationary times. Therefore, many companies feel that even if lower taxes are paid, the idea of lower net income is looked at negatively and isn’t a very good sign.
- LIFO Inventory Liquidation: One of the biggest disadvantages of the Last In First Out, LIFO method is the inventory liquidation of the previous stock. Since the newer stock is sold first, the previous stock is just lying around which is very difficult to sell off as trends and fashion keep changing. This leads to tons of dead stock, leading to cash being stuck, reflecting a weak cash flow.
- Understatement of Inventory: Using the Last In First Out, LIFO system, the balance sheet figure is usually understated and this may look worse as a whole picture for the company.
This is everything you need to know about Last In First Out, LIFO accounting methods.
FAQs about LIFO
What is the full form of LIFO?
The full form of LIFO is – Last In First Out
What is the LIFO method?
Under the Last In First Out method, the newer goods that make up for the inventory are sold off first and the older goods are yet kept in inventory. The newer goods and the prices of the newer goods are the figures that are then represented on the balance sheet and profit & loss statement.
What are the other inventory accounting methods?
There are mainly 3 inventory accounting practices which are:
- FIFO: First In First Out
- LIFO: Last In First Out and
- Weighted Average Method
Is LIFO allowed in India?
No. Last In First Out, LIFO is not allowed in India since there are a few disadvantages and the main being it isn’t a true representation of the business and the revenue and profits of the business.
Is it possible to manipulate the income and profit of the business under LIFO?
Yes. By using the Last In First Out, LIFO method, many companies and accounting firms can manipulate the income of the business and inflate or deflate the figures due to which more fraudulent activities can take place. Hence organizations prefer to follow the First In First Out, FIFO method or then the Weighted Average Inventory accounting method to keep stock of their goods and COGS.