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If you run a business with inventory, your management team can choose from a few different accounting options. Traditionally, the most common option is first-in-first-out, which essentially means that inventory goes out of your business in the same order that it comes in. However, many businesses can benefit from last-in-first-out (LIFO) accounting.
Here is a look at that method and an explanation of when an organisation may benefit from using this approach.
What is LIFO?
As implied by the name, last-in-first-out means that the last inventory you acquired will be the first to sell. Note that this applies to similar items. To give you an example, imagine that your business purchases 100 widgets for $1. Then, it purchases another 50 widgets for $2. Finally, it sells 40 widgets.
When determining the cost of the sold widgets using the LIFO system, you refer to the last-in cost which was $2. As a result, the 40 widgets you sold cost you $80 to buy.
What is the benefit of LIFO?
The LIFO method is particularly appealing to businesses that sell products that tend to rise in price. This method allows businesses to match their revenue to their latest costs.
To continue with the above example. imagine that the business sold the 40 widgets for $5 each. If it used the FIFO method, its cost for the widgets would have been just $40, and its profits would have been $160. However, this method doesn't capture the reality of the increased widget cost.
By using the LIFO accounting method, the cost of the widgets was $80 and based on a selling price of $5 each, the company's profits were just $120.
How does LIFO affect taxation?
LIFO can help to lower net income. Again, look at the example above. With the LIFO method, the company only showed $120 in profits, and its tax liability will be calculated based on that amount.
In contrast, if the company used the other inventory accounting method, its profits would have been $160, ostensibly driving up its income tax liability.
Is LIFO right for your business?
Identifying the best accounting methods for inventory and other aspects of your business can be challenging. to ensure you're taking an optimal approach, you may want to consult with an expert. They can look over your business management and accounting practices and help you identify the best option for your organisation. To learn more, reach out to a professional today.Share
10 January 2022