thelast-in,first-outaccountingmethod.pdf

The Last-in, First-out Accounting MethodThe Last-in, First-out Accounting Method The last-in, first-out (LIFO) procedure for expensing cost of goods sold (COGS) expenses in the opposite order of the natural flow of inventory. The last items received are the first expensed, so the LIFO method expenses the most recent purchases. LIFO generates a conservative report of a company's financial performance. LIFO also presents a realistic picture of the cost of continuing to produce the company's products by expensing products at the price closest to their replacement cost. Inventory figures LIFO focuses on the cost of replacing goods sold, rather than the original purchase price of goods sold. This increases the value reported as COGS, thereby decreasing reported net income. It also decreases the reported value of inventories. Unless all inventory, old and new, is cleared, the old inventory will never be cleared from the inventory figures. Over a long period of time, given normal inflation, LIFO results in a grossly undervalued inventory. Taxable income LIFO became very popular during the period of high inflation from 1970 to 1980. When costs rise dramatically, LIFO lowers a company's taxable income by maximizing cost of goods sold expense and thus subtracting more from revenues on the Income Statement. This reduces operating income results in a reduced taxable income for the company, meaning a company retains more money despite showing a reduced profit, because they pay less income tax. The LIFO procedure allows companies to show a conservative profit. Companies may want to use following methods: ● Minimize profits that are subject to profit sharing plans or bonuses. For example, a company that has profit sharing may choose LIFO because it reduces the amount of profit that will have to be distributed to employees. ● Hide profits during periods of labor problems or union contract bargaining. For example, union officials will be aware of the recording strategy employed during labor troubles, but a low reported net income can aid a company in the battle for public opinion. ● Raise prices to increase cash. For example, a company may use LIFO to artificially lower margins as a strategy to help justify price increases. If successful, this will increase the flow of cash into the company. file:///C|/Documents and Settings/kaa9502/My Docu...port/The Last-in, First-out Accounting Method.htm (1 of 2) [8/4/2009 11:31:48 AM]The Last-in, First-out Accounting Method● Minimize taxable income. For example, companies generally prepare separate books for their annual report and for their income tax filings. The procedure used to record cost of goods sold must be the same in both sets of books if they use LIFO. Affect on financial statements The most significant difference between LIFO and first-in, first-out (FIFO) is that the net income, or profit, recorded using LIFO is lower than it would be if FIFO had been used. Remember, however, that this is assuming rising prices. LIFO has a specific effect on each financial statement: ● Income Statement—The increase in COGS results in a decrease in net income. ● Balance Sheet—Retained earnings are decreased because of higher COGS, but this decrease is matched by a decrease in the valuation of assets. ● Cash Flow Statement—The decrease in net income and increase of cost of goods sold are undone on the Cash Flow Statement. Cash will increase because of lower taxes paid. Disclosing FIFO valuation Generally accepted accounting principles (GAAP) requires companies using the LIFO procedure to disclose what the cost of goods sold would be using FIFO valuation because of the potential for significant differences between the two procedures. This allows for easy comparisons among companies regardless of the reporting procedures used. However, companies using FIFO are not required to disclose their cost of goods sold using LIFO because FIFO follows the natural flow of inventory. The LIFO procedure expenses the most recent inventory purchases to cost of goods sold, and the cost of old stock is recorded in inventories regardless of the actual flow of physical inventory used by the company. If the oldest physical inventory is sold first, the company can expense it at the cost of the most recently purchased inventory. Since net income is reduced using this procedure, taxes payable will be reduced as well. Course: Analyzing an Annual Report Topic: Last-in, First-out (LIFO) Method SkillSoft Corporation, Copyright 2003. All brand or product names and their content mentioned in this product are the property, trademark, service mark, or registered trademark of their respective holders. file:///C|/Documents and Settings/kaa9502/My Docu...port/The Last-in, First-out Accounting Method.htm (2 of 2) [8/4/2009 11:31:48 AM]。