We are using Historical Cost to valuate our inventory. I know that some used car dealerships use LIFO to valuate their inventory. Could someone please explain why they would do so? Is it more advantageous to use LIFO for a used car dealership?
LIFO is last in first out, in terms of cost.
To use it you would have to be stocking and selling the same model car in qty. If you had 4 Dodge 1500 pickups in stock, then you could use LIFO so that when you sold one, the most recent (presumably higher) cost would post to COGS.
But if you only stock one Dodge 1500, well what you paid for it is LIFO, and FIFO, and specific cost since there is only one.
I think this might help you think of this differently. The way you phrased the question confuses Inventory Value and the computed Cost for a sale.
In your business, the Inventory value is what you paid for things. You scan the lot and add up what the purchases cost. That is Inventory Valuation.
Sales from inventory have different tax rules, but the question you had for LIFO or FIFO is related to the Cost of that Sale, not the Cost of Inventory on hand.
I bought 500 Widgets over time, varying from 85 cents to $1.23. The Inventory Valuation is all of the costs from purchases. The Cost when I sell something is FIFO or LIFO because for each sale, that Inventory carrying value is evaluated against what is being sold and what has been sold and that includes quantity now.
You would never buy $100,000 cost of 5 misc vehicles, then sell one truck or one sedan as if that was the $20,000 cost to you as average costing. You know that the sedan might have cost $2,000 and the Truck might have cost you $30,000. And which you bought in sequence would also be wrong for selling something different, now. You don't want FIFO, when you bought the sedan first, but sold the truck first.
That's why you use neither FIFO or LIFO for Sales Valuation.
Okay. Thank you for clearing this up for me. That is what I thought just wanted to make sure I understood this correctly.
I did have another question. I see other used car lots buy a lot of inventory at the end of the year. Is there a reason why they are doing so--tax wise? From what I understand in regards to COGS, there wouldn't be any tax benefit in it.
Operationally, buying inventory is not ever really part of Tax planning. It's part of Sales planning. Buying inventory does not reduce reportable income.
Every industry has a cycle, and I don't know yours. There might be a model year reason to stock up by the end of a year, or there are end of year Auctions for those needing to clear out stock that isn't moving, so a Used Card Dealership benefits from the timing of these sales. And some operations Floor their inventory, so they need to manage stock on hand more closely than others. Flooring through the manufacturer vs a third-party agency also matters.
For Sales planning, you have people getting end of year bonuses or anticipating tax refunds soon. That creates a selling opportunity in the next couple of months, for used car lots. You cannot sell what isn't available.
In regards to COGS, let's review:
Every financial perspective has Assets, Liability and Equity.
Assets = what you own
Liability = what you owe
Equity = the ownership position; or, the Leftovers, because "the accounting formula" is:
Assets = Liability + Equity
And you can reverse this, to:
Assets minus Liability = Equity
What you own minus what you owe = your true ownership position
I teach this in my class as:
If I get hit by a bus, you will need to Collect what is owed to me (AR is an Asset), and sell everything else I own; use that to pay off all my debt (AP is a Liability). The Difference is yours to party on = my ownership position = my Equity.
Now, the purchase of inventory is an Asset; you use funds (asset) or lending/borrowing, to pay for it. That doesn't change that you got More Asset = the cost is not Expense. The value is right in front of you, in that tangible Stuff = a vehicle. So, that isn't Spent, yet.
Then, you sell it. That means what you had on hand, is no longer on hand. It is a Cost of Goods that you Sold. That Lost Asset Value is the Expense it took you to have the possibility to Sell something. You sold what you bought, and the Value from Asset now it is an Expense, because of the sale (asset goes down and Expense goes up). The Sale is Gross Revenue. For meeting "the matching principle" then, you have:
Gross Revenue minus Expense (as COGS) = Profit for that date of sale.
Rent and electricity and printer paper are Expense right away = Poof! Already gone. Gone in this cycle = part of routine expense.
Purchase something to be sold, and you need to manage the turnover Cycle. While it is on hand, the money is still there in what is on hand; it's just not Cash, now. This is also why paying down Debt or the credit card balance or the mortgage principal are not Expense; they are Debt payments. All of this is on the Balance Sheet: Assets = Liability + Equity.