Why LIFO Is Banned Under IFRS

In 1981, the International Accounting Standards Board (IASB) introduced IFRSs. One of the first things that IASB did was to rule that physical inventories would not be carried at LIFO in the income statements. This rule was in effect even before IFRSs were published, but it was not given a name until much later. It is now referred to as the LIFO ban. A couple of years ago, there was a big push to get IFRSs to change this rule, or to remove it altogether.

Under the last revision of accounting rules, the LIFO inventory method was the only method allowed for computing inventory at the end of the year. (Before that, LIFO was allowed, but only for small businesses.) Because LIFO was the only method that sellers could use, the inventory valuations produced by LIFO-based methods were generally accepted by the market. Since LIFO does not reflect the cost of replacing inventory, it is the most inaccurate of the methods available.

Accounting Home Why LIFO is prohibited under IFRS

12. August 2020
Accounting Adam Hill

For example, in an inflationary environment, current dollar earnings are tied to older, cheaper stocks, maximizing gross margin. There are two popular accounting solutions to this problem. You’ve probably heard of them, as their acronyms are vaguely reminiscent of dog nicknames. The allocation of costs between inventories and cost of sales is based on the first-in, first-out (FIFO) and last-in, first-out (LIFO) methods used by most public companies.

What is included in the inventory valuation?

Inventory valuation allows a company to determine the monetary value of the items in its inventory. Inventories are generally the largest current assets of a company and their proper valuation is critical to the accuracy of the financial statements.

The product can absorb a wide range of fixed and variable costs. These costs are not expensed in the month in which the entity pays them. Instead, they remain under inventories until the inventories are sold, at which time they are deducted from the cost of production.

Determination of the value of unsold inventory at the end of the reporting period. Inventories are generally valued at the lower of cost and market value. Four common valuation methods are the first-in, first-out (FIFO) method, the last-in, first-out (LIFO) method, the average value method (AVCO) and the specific identification method. Under the FIFO method, the earliest purchased goods are removed from the inventory account first.

The specific identification costing method allocates costs to an identifiable inventory item. This method does not make assumptions about cost flow as other inventory valuation methods do. Conceptually, this method links costs to the physical movement of inventory and removes the emphasis on the timing of costing. The periodic and permanent inventory procedures in the specific identification method therefore lead to the same results. The first-in, first-out (FIFO) method of inventory costing assumes that the cost of goods purchased first is included in the cost of goods sold when the company actually sells the goods.

Calculation of cost of sales (recurring method)

What is the best method for estimating inventories?

The method used by an entity to determine the cost of inventories (inventory valuation) has a direct effect on the financial statements. The three principal methods of determining the cost of inventories are the first-in, first-out (FIFO) method, the last-in, first-out (LIFO) method and the average cost method.

Note that you can also determine the cost of goods sold for the year by recording the value of each item sold. The cost of goods sold of $509 is an expense in the income statement, and the $181 of inventory at the end of the period is a current asset in the balance sheet.

Inventory valuation is used to estimate cost of goods sold (COGS) and ultimately profitability. The most common valuation methods are FIFO (first in, first out), LIFO (last in, first out) and WAC (weighted average cost). The Last-In-First-Out (LIFO) inventory valuation method, although allowed in the United States.

This provision represents the amount for which the company’s taxable income is deferred under the LIFO method. To illustrate: Suppose an entity considers the 20 units available at year-end to be the 10 units available at year-end on August 12 and the 10 units on August 21. December can determine the units earned. The entity calculates ending inventory as shown below; it subtracts the value of ending inventory of $181 from the value of goods to be sold of $690 to obtain the value of goods sold of $509.

• Inventory valuation is used to estimate cost of goods sold (COGS) and ultimately profitability.

This method assumes that the goods bought first are also the goods sold first. In some businesses, the first units received (purchased) must also be the first units withdrawn (sold) to avoid significant losses due to spoilage. Goods such as fresh dairy products, fruits and vegetables should be sold on a FIFO basis. In these cases, the expected flow is first-come, first-served as the actual physical flow of goods.

LIFO and FIFO are the two most commonly used methods for booking inventory in the United States. The transition from one method to another may affect the company’s valuation, financial statements and tax returns. This is one of the most widely used methods for inventory estimation by companies because it is simple and straightforward. In the case of inflation, the FIFO method results in an increase in the cost of ending inventory, a decrease in the cost of goods sold and an increase in the gross margin.

In fact, incorrect inventory valuation results in two incorrect income statements. This is because the stock at the end of one reporting period automatically becomes the stock at the beginning of the next reporting period. The method used by an entity to determine the cost of inventories (inventory valuation) has a direct effect on the financial statements. The three principal methods of determining the cost of inventories are the first-in, first-out (FIFO) method, the last-in, first-out (LIFO) method and the average cost method.

Financial computation methods applied

Suppose a company replenishes its inventory with new goods that are worth more than the old inventory. Should the entity average all inventories when calculating cost of goods sold? Should he count the ones he bought earlier and cheaper?

FIFO (first in, first out)

Generally accepted accounting principles (GAAP), which are prohibited by International Financial Reporting Standards (IFRS). Because IFRS rules are based on principles rather than specific instructions, the use of LIFO is prohibited because of the potential distortions it can have on an entity’s profitability and financial statements. Cost accounting is a method of accumulating the costs associated with the production process and allocating them to the various products. This type of calculation is required by accounting standards to prepare an inventory valuation that is reported on a company’s balance sheet.

Use of non-cost methods to estimate inventory

In times of inflation, LIFO has the highest cost of goods sold of all cost accounting methods because the most recent costs attributable to the cost of goods sold are also the highest. The higher the cost of production, the lower the net profit. Proponents of the LIFO method argue that the costs and benefits of applying this method are more in line with each other than with other methods. When a company applies LIFO, the income statement reflects the revenues and costs of goods sold in current dollars. The resulting gross margin is a better indicator of management’s ability to generate revenue than the gross margin calculated under the FIFO method, which may include a significant return on (paper) inventories.

Inventory valuation

LIFO stands for last-in, first-out, which means that goods produced last are recorded as sold first. The difference between the cost of inventories determined according to the FIFO and LIFO methods is called the LIFO reserve.

Or perhaps the most recent inventory data should be used for the calculations. This decision is critical and will impact the company’s gross margin, net income and taxes, as well as the future valuation of inventory.{“@context”:”https://schema.org”,”@type”:”FAQPage”,”mainEntity”:[{“@type”:”Question”,”name”:”Why IFRS do not allow LIFO?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:” IFRS do not allow LIFO because it does not represent a true economic order.”}},{“@type”:”Question”,”name”:”Why is LIFO no longer used?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:” LIFO is no longer used because it is not a good way to value inventory.”}},{“@type”:”Question”,”name”:”Which inventory method is not allowed under IFRS?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:” The cash method is not allowed under IFRS.”}}]}

Frequently Asked Questions

Why IFRS do not allow LIFO?

IFRS do not allow LIFO because it does not represent a true economic order.

Why is LIFO no longer used?

LIFO is no longer used because it is not a good way to value inventory.

Which inventory method is not allowed under IFRS?

The cash method is not allowed under IFRS.