how does LIFO (Last in, First out) acts as a tax minimisation strategy for businesses (1 Viewer)

[moon_princess]

confused saw in textbook.

 

[RossoneriAU]

LIFO minimises tax as it attributes the most recent sales of goods to COGS. As new and better goods are put onto the market, businesses will be forced to pay more for these items (as they are higher quality than previous stock), yet may still sell them at the same price as prior models in order to remain competitive. (E.g. iPhone 4 may have initially been bought for $450 by a tech company and sold for $1000. As the iPhone 5 is introduced into the market, it may cost the company $500 to buy due to its better features, but the company may still sell them at $1000 to remain competitive in the market.) Therefore, if a company records sales of 1000 units of a good, the LIFO inventory method takes the 1000 most recently purchased (and thus most expensive units) and multiplies them by the respective price they were bought for in calculating Cost of Goods Sold (COGS). This makes LIFO's COGS much higher than FIFO's COGS as FIFO only takes the first 1000 units purchased (and thus the cheapest units) and multiplies them by the respective price they were paid for, thus resulting in lower COGS. As LIFO attributes the most recently bought and most expensive units to COGS, the first and cheapest units are put into ending inventory on the business' financial statements (and vice versa for FIFO). This means that LIFO overstates COGS (As it assumes only the most recently bought and expensive units had sold) whilst understating inventory (As it assumes that all of the initial and cheapest units had not sold). This is the opposite for FIFO, which understates COGS (As it assumes that all of the initial and cheapest units had sold) and overstates inventory (As it assumes that only the most recently bought and expensive units had not been sold)

If you think about the Income Statement, Gross Profit is deduced by the formula: Gross Profit = Sales - COGS. If COGS are overstated (as seen in LIFO), gross profit is understated and lower. Therefore, net profit is also reduced, and a company is taxed less as their total net profit figure is smaller.

To put it simply:
- LIFO = Higher COGS, Lower Profit, Lower Ending Inventory
- FIFO = Lower COGS, Higher Profit, Higher Ending Inventory

In regards to LIFO, its ability to minimise taxes has led to it being banned for use in Australia as well.

Sorry for the long-winded message, but I hope it helped

 

[moon_princess]

LIFO minimises tax as it attributes the most recent sales of goods to COGS. As new and better goods are put onto the market, businesses will be forced to pay more for these items (as they are higher quality than previous stock), yet may still sell them at the same price as prior models in order to remain competitive. (E.g. iPhone 4 may have initially been bought for $450 by a tech company and sold for $1000. As the iPhone 5 is introduced into the market, it may cost the company $500 to buy due to its better features, but the company may still sell them at $1000 to remain competitive in the market.) Therefore, if a company records sales of 1000 units of a good, the LIFO inventory method takes the 1000 most recently purchased (and thus most expensive units) and multiplies them by the respective price they were bought for in calculating Cost of Goods Sold (COGS). This makes LIFO's COGS much higher than FIFO's COGS as FIFO only takes the first 1000 units purchased (and thus the cheapest units) and multiplies them by the respective price they were paid for, thus resulting in lower COGS. As LIFO attributes the most recently bought and most expensive units to COGS, the first and cheapest units are put into ending inventory on the business' financial statements (and vice versa for FIFO). This means that LIFO overstates COGS (As it assumes only the most recently bought and expensive units had sold) whilst understating inventory (As it assumes that all of the initial and cheapest units had not sold). This is the opposite for FIFO, which understates COGS (As it assumes that all of the initial and cheapest units had sold) and overstates inventory (As it assumes that only the most recently bought and expensive units had not been sold)

If you think about the Income Statement, Gross Profit is deduced by the formula: Gross Profit = Sales - COGS. If COGS are overstated (as seen in LIFO), gross profit is understated and lower. Therefore, net profit is also reduced, and a company is taxed less as their total net profit figure is smaller.

To put it simply:
- LIFO = Higher COGS, Lower Profit, Lower Ending Inventory
- FIFO = Lower COGS, Higher Profit, Higher Ending Inventory

In regards to LIFO, its ability to minimise taxes has led to it being banned for use in Australia as well.

Sorry for the long-winded message, but I hope it helped

thank you thank you thank you!!! this really helped. i tried to get this explained by my teacher multiple times and i still didn't get it ahahha thank you, i really appreciate it