Question

You did an outstanding job on your response! I’m so glad that you mentioned LIFO! That’s a substantial difference between U.S. GAAP and IFRS. Under IFRS, companies are not permitted to use the LIFO (last-in, first-out) method of inventory costing. Class, what are the advantages and disadvantages of this approach? Do you agree with IFRS on this matter? Why or why not? Also, what are some reasons why some U.S. companies might be reluctant to let go of this costing approach? Brandy

Answer 1

This is the method of inventory valuation, where the material received last would be issued first for production purpose.

Advantages are as below:

Point 1) This system is appropriate at the time of rising prices, since production is being changed with higher prices for the recovery of such prices at the earliest.

Point 2) This is the way of charging current price of material in the total cost of production, which becomes realistic.

Point 3) There should not be any unrealized profit of ending inventory in the income statement, since it is valued at earlier lower price.

Disadvantages are as below:

Point 1) If there is price fluctuation invariably, this system makes clerical error.

Point 2) If price starts falling, there would be low charge to production which creates ambiguity.

Point 3) Since the ending inventory shows earlier price, it becomes unrealistic as per the present market condition. This is the under-statement of asset in the balance sheet too.

The matter of IFRS: The IFRS banned LIFO method, because it lowers the net income which ultimately decreases tax-liability of the entity. It happens because of charging higher material price to the cost of goods sold, which reduces gross profit and net income. I agree the stand of IFRS, because charging such higher price artificially for distorting the net income becomes a common practice in the US; this is the way of neglecting tax, which can’t be tolerated. Moreover, the balance sheet of an entity becomes outdated because of recording inventory in earlier price; this thing disturbs the interest of financial statements users (like bank, shareholders, lenders, etc).

Reluctant: The US companies are reluctant because they may lose tax benefits out of this system if the system is gone. LIFO gives them immense scope of showing lower income and paying lower tax, which they don’t want to go.