LIFO does not have to agree with the actual physical movement of goods. The only requirement is: The total cost of goods sold plus the cost of the ending inventory is equal to the cost of goods available for sale. Cost flow assumptions are timing issues. Over the life of the firm the total cost of goods sold for financial reporting and tax purposes must be equal to the total price paid for inventory.
Disadvantages of LIFO
a. Inventory cost presented on the Balance Sheet is not close to current value. LIFO results in significantly understated inventory values (assets) if it has been used for a significant length of time and/or if there is significant inflation.
b. Subject to management manipulation. For example, to increase net income, the company may select to not purchase as much inventory and use up some or all of a LIFO "layer" which, if the inventory is old and at a much cheaper price, will artificially increase gross margin and net income
c. LIFO requires significant record keeping and careful management of purchases
Financial Statement Problems with LIFO
A major potential problem is the possibility of "involuntary LIFO liquidation" of inventory. This may result from unexpected high sales volume at the end of the accounting period.
A LIFO liquidation results when a company experiences declines in inventory quantities. In this case, older inventory is sold or liquidated. This creates an inflated profit margin distorts net income.
Arises when purchases for the period are not sufficient to offset the sale of inventory in the period. The older costs in the LIFO layer liquidated are matched with current sales dollars. In other words, previously ignored holding gains are included in income as old layers are liquidated.
a lower income number than
FIFO, thus lowering the immediate tax liability (assuming increasing
These cash flow
benefits can induce undesirable managerial
a. This may happen if a firm has depleted its inventories during the year and it wants to avoid the tax liability associated with the LIFO liquidation.
b. A manager can avoid taxes by simply purchasing a large amount of inventory at the end of the year to bring it back up to beginning-of-year levels.
c. To increase net income, the company may select to not purchase as much inventory and use up some or all of a LIFO "layer" which, if the inventory is old and at a much cheaper price, will artificially increase gross margin and net income
* If a LIFO liquidation occurs, the company should disclose this information in a disclosure note