Why LIFO is banned under IFRS

The LIFO method, or “Last-In, First-Out,” is an accounting method used to calculate the value of a company’s inventory and determine the cost of goods sold. The International Financial Reporting Standards (IFRS) have banned the LIFO method (What is IFRS?).

Following the LIFO method, the most recent purchases are sold first, which means that the cost of the newer inventory is used to calculate the cost of goods sold. These newer costs are often higher than older costs (inflation). And, higher costs mean less profit, means paying less tax. In many cases, the LIFO method can therefore be advantageous for companies.

The LIFO method is prohibited under IFRS for the following reasons: violating the principle of consistency and matching, distortion of a company’s profit and financial position, and failure to comply with IFRS inventory valuation regulations.

All this may sound a bit unclear, but rest assured. In this article, I will try to clearly explain the main reasons of the IFRS to ban the LIFO method.

In conflict with accounting principles

IFRS requires inventories to be measured at the lower of the purchase price and net receivable value (NRV). In other words, the value of the inventory should be based on the lower of the purchase price and the price at which the goods can be expected to sell.

Furthermore, IFRS is based on a number of important principles that should ensure greater transparency and consistency within accounting. The LIFO method violates at least two of these principles: the consistency principle and the matching principle. Below, I explain why the LIFO method contradicts each of these principles.

LIFO method violates the principle of consistency

One of the main reasons why the LIFO method is not allowed by IFRS is that it violates the principle of consistency. Consistency is a fundamental accounting principle that states that a company must use the same accounting method for similar transactions in successive financial years.

However, the LIFO method makes it difficult to maintain a consistent valuation of inventory because the cost basis of inventory is constantly changing as new purchases are made and older purchases are sold. This can lead to inconsistencies in financial reporting from year to year.

For example, businesses can use the “First-In, First-Out” (FIFO) method or the “Weighted Average Cost” (WAC) method (also known as the Fixed Transfer Price (FTP) method) to calculate the value of their inventory and determine the cost of goods sold. These methods are considered to be more consistent and reliable than the LIFO method.

LIFO method in violation of the matching principle

One of the most important principles is the matching principle, which requires that the costs are matched with the corresponding revenues in that same period. This is not the case with LIFO, because (in most cases) the older, cheaper stock is sold first. This while the newer stock has been sold from an accounting point of view.

The costs attributed to the sale are therefore higher than they actually are. This can lead to a distorted view of the profit and loss account, as the costs do not match the revenues.

LIFO method ‘cheaper’

In many cases, the LIFO method is more advantageous than the FIFO or WAC method because it often results in less profit, and therefore less tax to pay. It also reduces comparability between companies, which can mislead investors, investors or other stakeholders. In conclusion, the LIFO method results in an outdated inventory valuation and a lower profit margin.

Outdated inventory valuation

A third reason why the LIFO method is not allowed by IFRS is that it can lead to a distorted view of the value of a company’s inventory. Because the LIFO method sells the most recent purchases first, the value of the inventory that is recorded in the books may be out of date and may not match the actual market value of the inventory. This can jeopardize the accuracy of a company’s financial reporting and can mislead investors and other stakeholders about the company’s true financial position.

Lower profit = less taxes

Another reason why the LIFO method is not allowed by IFRS is that it can lead to a distorted view of a company’s actual profit and financial position. When using the LIFO method, the most recent, and often more expensive, purchases are sold first, increasing the cost of goods sold and reducing profit margins. As a result, the profit tax to be paid will be reduced. This can lead to a distorted view of a company’s performance and can reduce the comparability of financial information between different companies.

Where is the LIFO method allowed?

While the LIFO method is still allowed for tax purposes in some countries, many countries, including most European countries, have abolished or restricted the LIFO method. In these countries, a different method is usually used for financial reporting that is in line with IFRS regulations. In the United States, however, the LIFO method is still permitted. American companies do not have to comply with IFRS, but with the United States Generally Accepted Accounting Principles (US GAAP). Only in case an American company is a subsidiary of a foreign company that must report according to IFRS, they also have to report under IFRS.

Difference IFRS and US GAAP

Although efforts are being made to make IFRS and US GAAP the possible same, there are still a number of important differences. This must be clear to investors or other stakeholders active in both regulations in order to be able to properly analyse the financial information of companies. Apart from the fact that the US GAAP does allow the LIFO method, there are some, but certainly not all, differences:

• Framework vs. Rules: US GAAP is based more on specific rules and guidelines for different accounting issues. In contrast, IFRS is based on a more principle-oriented approach, focusing on the application of general principles and the use of professional judgment.
• US GAAP uses different criteria for classifying leases as operational or financial, while IFRS takes a more principled approach. This can lead to differences in how lease liabilities and assets are disclosed in the financial statements. IFRS introduced IFRS 16 as a new form of lease treatment, read the explanation of IFRS 16 here.
• Research and Development: U.S. GAAP treats research and development (R&D) expenses differently than IFRS. For example, US GAAP often requires research expenses to be recorded as expenses, while IFRS allows certain research activities to be capitalized as assets.

Summary

The LIFO method is an accounting method that calculates the value of a company’s inventory and determines the cost of goods sold based on its most recent purchases. Despite the advantages that this method can offer, IFRS has banned the LIFO method for several reasons.

IFRS strives for consistency, transparency and reliability in financial reporting. However, the LIFO method violates two important basic principles, such as the principle of consistency and the principle of matching. Using the LIFO method makes it difficult to maintain consistent valuations of inventory and can lead to inconsistencies in financial reporting from year to year. In addition, costs are not adequately aligned with the associated revenues, which affects the accuracy of the profit and loss statement.

Another disadvantage of the LIFO method is that it can lead to a distorted view of the value of a company’s inventory and profits. Because the newer, more expensive inventory is sold first, the profit margin becomes lower and the tax payable is reduced. This can reduce comparability between companies and mislead investors and other stakeholders about a company’s true financial position because the value of the stock is not up to date.

While the LIFO method is still allowed in some countries, many countries have chosen to abolish or restrict this method. In the United States, however, the LIFO method is still allowed, as U.S. companies must comply with the United States Generally Accepted Accounting Principles (US GAAP), which differ from IFRS in several areas.

Instead of the LIFO method, it is important to use alternative methods, such as the FIFO method or the Weighted Average Cost method. This is because they are in accordance with the IFRS guidelines.

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