3.10 Inventory Accounting Issues: LIFO
Of course, the previous example was “loaded” in that purchase costs rose dramatically over time. In reality, prices tend often to rise with inflation, so the direction of the results in actuality would not be affected. If, in fact, costs declined over the considered periods, the direction of the results would be exactly reversed, and your choice of method, if you anticipated this alternate outcome, would be different accordingly. Here are some relevant upcoming questions.
- What is meant by “LIFO Base”?
- What is the effect of costing units sold from the base?
- There is a technical problem in connection with interim reporting under LIFO (in FIFO too).
Using the foregoing example, imagine that the firm –indefinitely into the future –regularly purchased four units and sold four units. Imagine also that there continued to be some inflation.
A firm cannot accurately provide its LIFO inventory figure until it closes the books on the period. More specifically, the firm cannot figure the Cost of Goods Sold, and therefore its LIFO inventory until it has, quite literally, made the last inventory purchase and thus knows the costs of units acquired.
It would be conceivable that after some time, inventory costs and sales prices would be quite high, say $20 per unit – theoretically. Still, that one very “old” unit, which is being carried at a historical (ancient!) cost, would reflect a very low “cost basis” of, say $1, representing the inventory’s LIFO Base. (See the example on the next page.) If many years later, the firm suddenly then sold five units, it would dig into or “cost out” its LIFO base and reflect a very high profit for that item. This now high profit on that unit would be contrary to the firm’s motivation for adopting LIFO in the first place, which is to minimize profits and consequently its tax liabilities.
By example, let’s say the firm is on a calendar year fiscal cycle. It cannot know in the interim, say, in November, what the December year-end inventory shall be. In our earlier case, the fourth unit purchased is the first out and first charged to COGS. The third acquired is the second to go, etc. We count backwards starting with the last one in! We cannot know what the last one’s cost is – until the last one is in! (True, this problem pertains to FIFO, but is less worrisome analytically.) An illustration of this problem follows on the next page.
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