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LIFO is sometimes used by companies in order to lower their tax liabilities. This occurs in...

LIFO is sometimes used by companies in order to lower their tax liabilities. This occurs in a time of rising prices. Can you explain why this lowers their tax burden and what the effect this would have on the inventory valuation on the balance sheet?

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Answer #1

LIFO is the last in first out method. It is used in the assumption that the goods which are purchased recently are also the ones which are sold first. In an inflation condition, price of the goods will be continuously increasing. Therefore the cost of goods sold under LIFO method will be higher than any other valuation method as the goods sold first are the latest and highest cost ones.

Since the cost of goods sold is higher, the profit realised is reduced which directly impact the taxable income and thereby tax liability is lowered.

While using this method, the value of closing inventory will be lower than any other method and it will affect the profit of upcoming years.

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