Last in, first out accounting refers to a way of determining the value of your small business’s inventory. LIFO accounting assumes you sell or use your most recent inventory first. This accounting method presumes the item you produce or buy first is the last one you sell. On a balance sheet, you run expenses for the latest goods you buy or produce first. This accounting method helps maintain more accurate records, particularly if the costs of producing or buying inventory change from the first item to the last.
How LIFO Accounting Works
For example, you have an inventory of three widgets you bought six months ago. Then, you added three identical widgets three days ago that cost more than the original batch. A customer buys four widgets from your total inventory of six. LIFO accounting assumes three of the purchased widgets came from the second, or more recent, batch, while one widget comes from the first batch you purchased six months ago.
- Original three widgets from six months ago: $10 each
- Three more widgets from three days ago: $15 each
- Customer buys four widgets from you at $20 each
- Total sale: $20 x 4, or $80
- Total cost of four widgets: $15 x 3 and $10 x 1, or $55
- Gross margin: $80 – $55 = $25
LIFO accounting gives you a more accurate and current picture of the transaction and how much profit you clear from each sale.
Why LIFO Accounting Is Important to Your Business
During inflation, LIFO accounting often lowers net income because costs of inventory tend to increase when your raw materials cost more. The Canada Revenue Agency and International Financial Reporting Standards don’t allow the use of LIFO for inventory valuation in terms of financial reporting or tax purposes.
But you can still use LIFO accounting to benefit your business for your internal records. LIFO improves income matching statements when you analyze your current expenses. Selling more recent widgets in your inventory matches better with the expenses you incur to buy or produce them. The LIFO method helps you to align your income versus costs during a more recent reporting period versus one from six months ago when you bought the older widgets.
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