You are watching: Which of the following is not a reason why companies prefer certain accounting methods?
Amy is an ACA and also the CEO and also founder of OnPoint Learning, a financial training company transporting training to financial specialists. She has nearly two decades of suffer in the financial sector and also as a financial instructor for sector experts and people.
The last in, initially out (LIFO) technique of inventory valuation is prohibited under International Financial Reporting Standards (IFRS), though it is allowed in the United States, which provides mainly accepted audit principles (GAAP).
IFRS prohibits LIFO as a result of potential distortions it may have on a company"s profitcapability and also financial statements. For instance, LIFO deserve to understate a company"s earnings for the objectives of keeping taxable earnings low. It can additionally lead to inventory valuations that are outdated and obsolete. Finally, in a LIFO liquidation, unscrupulous managers may be tempted to artificially inflate income by marketing off inventory via low transferring expenses.
Underproclaimed Net Income
LIFO is based upon the principle that the latest inventory purchased will be the first to be offered. Let"s study how LIFO vs. initially in, first out (FIFO) accounting results a hypothetical firm, Firm A.
|Acquisition Year||Units Purchased||Cost Per Unit||Total Cost of Inventory|
Now assume Firm A sells 3,500 units in Year 5 at $2.00 per unit. This offers the company $7,000 in revenue. Under FIFO, the full price of items marketed (COGS) would certainly be caclulated as follows:
|Year 1||1,000||x $1.00||$1,000|
|Year 2||1,000||x $1.15||$1,150|
|Year 3||1,000||x $1.20||$1,200|
|Year 4||500||x $1.25||$625|
|Total Cost of Goods Sold||$3,975|
Total gross profit would certainly be $3,025, or $7,000 in revenue – $3,975 price of items sold. The worth of the remaining inventory is $1,925. That"s 500 systems from Year 4 ($625), plus 1,000 units from Year 5 ($1,300).
|Year 5||1,000||x $1.30||$1,300|
|Year 4||1,000||x $1.25||$1,250|
|Year 3||1,000||x $1.20||$1,200|
|Year 2||500||x $1.15||$575|
|Total Cost of Goods Sold||$4,325|
Total gross profit would certainly be $2,675, or $7,000 in revenue – $4,325 expense of goods marketed. The value of the remaining inventory would certainly be $1,575. That"s 1,000 devices from Year 1 ($1,000), plus 500 systems from Year 2 ($575).
As you deserve to watch, Firm A appears even more profitable under FIFO, also though the agency has marketed the exact very same number of devices, purchased at the exact same prices. It may seem counterproductive for administration to seemingly underreport profit, yet the benefit of LIFO stems from the tax benefits. Since the greater COGS has the impact of lowering gross revenues, carriers that usage LIFO are able to lessen their tax bill. But this decrease in taxation liability comes at a price: a greatly outdated inventory value.
Outdated Balance Sheet
The other point that happens through LIFO is the inventory worth as reflected on the balance sheet becomes outdated. For instance, imagine that Firm A buys 1,500 systems of inventory in Year 6 at a expense of $1.40.
Now let"s say Firm A then sells 1,500 devices in Year 6. Under FIFO, Firm A doesn"t touch any kind of of the inventory it added in Year 6. It still has units staying from Years 4 and also 5. Because of this, its COGS would be $1,925 (or $625 + $1,300). The value of its continuing to be inventory is $2,100 (i.e., all the systems included in Year 6).
However, under LIFO, Firm A pulls straight from Year 6 inventory. Its COGS is $2,100. The value of its continuing to be inventory is $1,575 (i.e., old stock from Years 1 and 2).
The balance sheet under LIFO clearly represents outdated inventory that is 4 years old. Additionally, if Firm A buys and also sells the exact same amount of inventory every year, leaving the residual worth from Year 1 and Year 2 untouched, its balance sheet would certainly proceed to deteriorate in relicapability.
LIFO Example: ExxonMobil
This scenario occurs in the 2010 financial statements of ExxonMobil (XOM), which reported $13 billion in inventory based upon a LIFO presumption. In the notes to its statements, Exxon disclosed the actual cost to rearea its inventory gone beyond its LIFO worth by $21.3 billion. As you have the right to imagine, under-reporting an asset"s worth by $21.3 billion have the right to raise significant concerns about LIFO"s validity.
Outdated inventory valuations have the right to seriously distort a company"s true financial picture when the assets are lastly sold. This brings to light one more controversial point in the direction of LIFO: LIFO liquidations. Let"s go earlier to our earlier instance of Firm A. In Year 6, it maneras to offer out all 3,000 units of inventory at $2 each, for $6,000 in revenue.
Thus, its gross profit from selling out its inventory would be $1,975, or $6,000 in revenue – $4,025 in COGS.
Because of this, its gross profit would be markedly greater at $2,325, or $6,000 in revenue – $3,675 in COGS.
When a LIFO liquidation has developed, Firm A looks much even more profitable than it would certainly under FIFO. This is because old inventory expenses are matched through existing revenue. However, it"s a one-off situation and also unsustainable bereason the seemingly high profit cannot be repeated.
In difficult times, administration might be tempted to liquiday old LIFO layers in order to temporarily artificially inflate profitcapability. As an investor, you deserve to tell whether a LIFO liquidation has actually arisen by studying the footnotes of a company"s financial statements. A tell-tale sign is a decrease in the company"s LIFO reserves (i.e., the difference in inventory in between LIFO and the amount if FIFO was used).
While some could argue that LIFO much better mirrors actual existing expenses to purchase inventory, it is apparent that LIFO has actually a number of shortcomings. LIFO understates profits for the functions of minimizing taxable revenue, results in outdated and also obsolete inventory numbers, and also can develop methods for monitoring to manipulate revenue through a LIFO liquidation. Due to these involves, LIFO is prohibited under IFRS.
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