Understanding Business Accounting For Dummies, 2nd Edition (99 page)

The more product cost you take out of the stock asset to charge to cost of goods sold expense, the less product cost you have in the ending stock. In maximising cost of goods sold expense, you minimise the stock cost value.

But here are the reasons why LIFO, in our view, is usually the wrong choice (the following sections of this chapter go into more details about these issues):

Unless you base your sales prices on the most recent purchase costs or you raise sales prices as soon as replacement costs increase - and most businesses don't follow either of these pricing policies - using LIFO depresses your gross margin and, therefore, your bottom-line net income.

The LIFO method can result in an ending stock cost value that's seriously out-of-date, especially if the business sells products that have very long lives.

Unscrupulous managers can use the LIFO method to manipulate their profit figures if business isn't going well. Refer to ‘Manipulating LIFO stock levels to give profit a boost' later in the chapter.

Note:
In periods of rising product costs, it's true that FIFO results in higher taxable income than LIFO does - something you probably want to avoid, we're sure. Nevertheless, even though LIFO may be preferable in some circumstances, we still say that FIFO is the better choice in the majority of situations, for the reasons discussed earlier, and you may come over to our way of thinking after reading the following sections. By the way, if the products are intermingled such that they cannot be identified with particular purchases, then the business has to use FIFO for its income tax returns.

The greying of LIFO stock cost

If you sell products that have long lives and for which your product costs rise steadily over the years, using the LIFO method has a serious impact on the ending stock cost value reported on the balance sheet and can cause the balance sheet to look misleading. Over time, the cost of replacing products becomes further and further removed from the LIFO-based stock costs. Your 2008 balance sheet may very well report stock based on 1985, 1975, or 1965 product costs. As a matter of fact, the product costs used to value stock can go back even further.

Suppose that a major manufacturing business has been using LIFO for more than 45 years. The products that this business manufactures and sells have very long lives - in fact, the business has been making and selling many of the same products for many years. Believe it or not, the difference between its LIFO and FIFO cost values for its ending stock is about £2 billion
because some of the products are based on costs going back to the 1950s, when the company first started using the LIFO method. The FIFO cost value of its ending stock is disclosed in a footnote to its financial statements; this disclosure is how you can tell the difference between a business's LIFO and FIFO cost values. The gross margin (before income tax) over the business's 45 years would have been £2 billion higher if the business had used the FIFO method - and its total taxable income over the 45 years would have been this much higher as well.

Of course, the business's income taxes over the years would have been correspondingly higher as well. That's the trade-off.

Note:
A business must disclose the difference between its stock cost value according to LIFO and its stock cost value according to FIFO in a footnote on its financial statements - but, of course, not too many people outside of stock analysts and professional investment managers read footnotes. Business managers get involved in reviewing footnotes in the final steps of getting annual financial reports ready for release (refer to Chapter 8). If your business uses FIFO, your ending stock is stated at recent acquisition costs, and you do not have to determine what the LIFO value may have been. Annual financial reports do not disclose the estimated LIFO cost value for a FIFO-based stock.

Many products and raw materials have very short lives; they're regularly replaced by new models (you know, with those ‘New and Improved!' labels) because of the latest technology or marketing wisdom. These products aren't around long enough to develop a wide gap between LIFO and FIFO, so the accounting choice between the two methods doesn't make as much difference as with long-lived products.

Manipulating LIFO stock levels to give profit a boost

The LIFO method opens the door to manipulation of profit - not that you would think of doing this, of course. Certainly, most of the businesses that choose LIFO do so to minimise current taxable income and delay paying taxes on it as long as possible - a legitimate (though perhaps misguided in some cases) goal. However, some unscrupulous managers know that they can use the LIFO method to ‘create' some profit when business isn't going well.

So if a business that uses LIFO sells more products than it purchased (or manufactured) during the period, it has to reach back into its stock account and pull out older costs to transfer to the cost of goods sold expense. These costs are much lower than current costs, leading to an artificially low cost of goods sold expense, which in turn leads to an artificially high gross margin figure. This dipping into old cost layers of LIFO-based stock is called a
LIFO liquidation gain.

This unethical manipulation of profit is possible for businesses that have been using LIFO for many years and have stock cost values far lower than the current purchase or manufacturing costs of products. By not replacing all the quantities sold, they let stock fall below normal levels.