Advantages of LIFO Inventory Valuation
Valuation of inventory is often a very significant aspect of not only a company’s accounting but also its performance. The accuracy of inventory valuation is imperative to a company’s financial statements as well as potential tax effects that could result from different valuation methods. Three of the most commonly used inventory valuation methods used are average cost, first-in first-out (FIFO), and last-in first-out (LIFO), all of which have various advantages and disadvantages. LIFO is often overlooked, but may prove to be more advantageous than the others in the right situations.
Benefits of LIFO Inventory Valuation
The LIFO inventory valuation method is when the last item of inventory purchased is the first item that is sold. An advantage of this method, in terms of reporting, is that LIFO provides a better measurement of current earnings. Under this method the most recent costs are matched against current revenues, compared to the FIFO inventory method which matches old costs against current revenues. Therefore, the reliability of current earning are improved using LIFO inventory valuation.
The largest benefactors of the LIFO inventory valuation method are those in an inflationary market, as this method would result in a higher cost of goods sold and a lower profit when compared to other inventory valuation methods. As a result, this lower profit causes a reduced income tax and could potentially improve the cash flows of a company.
The use of LIFO could also minimize the number of inventory write-downs to market during periods of inflation. Much of the inventory on hand under LIFO is older inventory that would be priced lower, as the newer, higher priced inventory would be when sold. Therefore, if prices began to drop in the future, there is a less likely chance that inventory would have to be written down.
As mentioned above, one of the main advantages of using LIFO inventory valuation is that profits will often be lower, causing a lower income tax expense. The lower profits could also potentially be a drawback of the LIFO method for companies wishing to obtain shareholders or additional financing as higher profits is a common indicator of a company’s performance which is often a key factor for investors and financers.
If you are not currently using the LIFO inventory valuation method, contact your trusted advisor at Apple Growth Partners to talk through the complexities and benefits of this option. We can conduct a feasibility study to determine the impact LIFO would have on your balance sheet, income statement and in potential tax savings.