Why US Companies Should Abandon the LIFO Method of Inventory Valuation
Accounting principles in the US and abroad have converged in the recent years, but one issue that US GAAP and IFRS (international financial reporting standards) remain divided on is methods of inventory valuation. While US GAAP permits first in first out (FIFO), last in first out (LIFO), and weighted average methods of inventory valuation, IFRS permits only the FIFO and weighted average methods. In this article, I will argue that the US should also outlaw the LIFO method of inventory valuation and switch to IFRS’ policy of allowing only the FIFO and weighted average methods.
Imagine a company that operates using the LIFO method of inventory valuation. This company operates under the assumption that it’s most recent (last in) inventory purchase will also be the first inventory item off the shelf (first out). Contrast this with a company that uses FIFO. A company that uses FIFO operates under the assumption that its oldest inventory pieces (first in) will be the first inventory off the shelf (first out). While the difference may not seem significant or even noteworthy, there are several consequences of using LIFO that I will discuss. Before I begin it is important to note that these statements are based on the assumption that prices are rising. While this is usually the case, there are times when prices fall for a period of time. However the following statements are made assuming that prices are rising.
In a period of rising prices, the inventory that a company purchases in an operating period will be more expensive than the inventory they already had on hand, which was presumably purchased during a previous operating period when prices were lower. Recall that LIFO stipulates that the most recent inventory purchases will be the first inventory pieces to be sold. By selling the more recent, and more expensive pieces of inventory first, a company incurs higher operating expenses for the period. While this may seem counter intuitive because it actually lowers a company’s net income, it is desirable for corporations because it also lowers the amount of income taxes to be paid.
I argue that LIFO should be outlawed for this reason alone. This method of accounting is not representative of how business operations work, and is nothing but a gimmick used by corporations to cheat their way out of tax payments. This kind of manipulation leads to accounting that is neither conservative nor honest, which should be reason alone not to use it.
There are other reasons to ban the use of LIFO. During a period of prolonged price increase, LIFO causes inaccurate inventory information. Because the newest pieces of inventory are the first to be sold, old inventory pieces can stay buried on a balance sheet for years. Those inventory pieces will have current, inflated prices assigned to them, and yet they may be outdated or obsolete. This can result in inventory values that are way off the mark. This is a major problem because for many companies, especially retail companies, their stock of inventory may be the biggest asset on their balance sheet. We cannot be accounting for these inventories in such a way that leads to dishonest inventory valuation.
Given that the FIFO and weighted average methods of inventory valuation do not lead to these problems, they are the methods that should be used. Making the switch may not be desirable for companies that have been using LIFO, but it will lead to better long term accounting. IFRS has already made the switch and it is time for the US to follow suit. The responsible choice is to choose better long term accounting.