When managing a business, it is necessary to keep purchase and sale records of inventory for tax purposes. This is done to justify expenses and revenues to the Internal Revenue Service. A business has the choice of which accounting method it would like to use for its inventory. The dollar value LIFO inventory method is one option that gives the advantages of lower federal taxes and a better view of a company's profitability.
The Matching Principle
Accounting standards require businesses to follow the matching principle when managing their expenses and revenues. This means that the expense of acquiring inventory should only be realized when the inventory is sold to a client. The costs and profits of a transaction must be realized at the same time. For example, a company buys a tractor for sale at a later date. Two years later, it sells the tractor for a profit. The expense of buying the tractor can only be realized at the time of sale, not when it is initially purchased.
Companies with high inventory turnover need an organized system to keep track of their inflows and outflows. Keeping track of each piece of inventory is too time consuming. The LIFO inventory method is one system commonly used. LIFO stands for last in, first out. Goods sold by a company are assumed to be those most recently purchased by the company. The most recent expenses of inventory are matched to current revenues.
Lower Federal Taxes
One advantage of the LIFO method is that it leads to lower inventory profit, which results in lower taxes. Due to inflation, the cost of goods sold tends to rise over time. It becomes more expensive for a company to stock up on inventory. By selling the most recently purchased and most expensive goods first, a company's reported revenue will be smaller. Lower revenues result in lower federal taxes being due.
Better Measure of Current Profitability
The LIFO method also gives a business a better representation of its current profit margin. By matching the expense of most recent costs to the current selling price, a company can see the current profit being made on each good sold. Using the expense amount of old inventory could create an illusion of profitability. If the cost of goods sold has recently risen, putting a business in trouble, using a LIFO method of accounting would show this problem.