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I was reading about inventory valuation and of course there is first-in - first-out, last-in - first-out and weighted average. I realized at some point that LIFO would cause the highest Cost Of Goods Sold and therefore the lowest profit, in situations where the cost of purchased inventory was rising, so I figured that was a stupid method. But the book I was reading said that LIFO is commonly used in the US as part of Generally Accepted Accounting Practices (bingo!) and not allowed by international standards (IFRS).

So I wondered why a company would want to under-report profit? Well, because it lowers taxes. Is that really such a powerful reason? Wouldn't the increased profit be higher than the increased taxation in normal cases? Is this just an attempt to spite the government or something?

Also, I read that occasionally, the old inventory that has been "on the books" for a long time at a very undervalued cost can be "sold off" and generate a profit spike (just in case you did want to earn some money). These kind of machinations are unintuitive, to me.

My question is, why was this crazy method allowed at all? Historical reasons? Because it took a while for government to wise up? Why has it not been killed off because it is manipulating tax revenue and corporate reporting?

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migrated from money.stackexchange.com May 19 '16 at 4:35

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  • $\begingroup$ You need to think like a company to understand them. Honesty and transparency are nice, and paying taxes is honorable, but neither is the primary goal of a company. They are founded to make money, and if LIFO helps them, they use it. The right to it is now grandfathered in, as it was used for thousands of years. Proposing a law to change it would result in the proposer's career ending rather suddenly because he is out of money for reelection. $\endgroup$ – Aganju May 18 '16 at 2:41
  • $\begingroup$ If there is a "cost plus" situation, higher cost of goods : more revenue. Also, think taxis, airlines, trucking companies and fuel surcharges. The fuel surcharge is based on the last fuel price. $\endgroup$ – user662852 May 18 '16 at 11:05
  • $\begingroup$ Today's clever question title :) $\endgroup$ – Joe Blow May 18 '16 at 15:58
  • $\begingroup$ I'm voting to close this question as off-topic because this is not about Economics. $\endgroup$ – FooBar May 27 '16 at 17:37
  • $\begingroup$ @FooBar The question title is not so clever now, after it was edited. If the question is not about Economics, what is it about? There are two financial-related SE sites: Money and Economics. When I add a question to one, it gets migrated to the other, as off-topic, then closed on the other, as off-topic. Will the real site please stand up? $\endgroup$ – user7706 May 27 '16 at 19:11
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well, LIFO also lowers the value of held inventory too...IF one special thing is occurring: Inflation.

When there is inflation, LIFO makes things look, well, a little bit better. During deflation (or flat) FIFO makes more sense.

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  • $\begingroup$ Inflation is the norm, isn't it? After all, without it, no one could make any money (except oil companies). $\endgroup$ – user7706 May 18 '16 at 12:25
  • $\begingroup$ @nocomprende, that's mostly always true IN THE AGGREGATE. (inflation the norm) However, when considering the specific costs of a particular inventory, it is by no means assumable. Take, for example, the value of a silo of corn in a bumper-crop year. $\endgroup$ – dwoz May 22 '16 at 17:30
  • $\begingroup$ Yes, I have never ever understood why prices rise and fall with supply and demand. I need to eat X amount no matter what. I need Y amount of gas for my car, no matter what. Why should they get cheaper sometimes? I can't buy and eat more, or pour gas on the ground just because it is cheap. Similarly, no one can make money raising prices, because I would have to spend less. I can't just spend more because you feel like raising the price. It is a completely mysterious and stupid concept, divorced from any knowledge of reality. $\endgroup$ – user7706 May 22 '16 at 22:49
  • $\begingroup$ @nocomprende You are kidding, right? Or do you have exactly 0 dollars left over at the end of every month? If not, you could have spent more. Similarly, do you ever exercise? By cutting that you could eat less. Usually there are always lower priced substitutes available as well. These are all ways you could reduce your consumption of a good after a price increase. $\endgroup$ – Giskard May 27 '16 at 18:36
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As you have pointed out yourself, minimization of taxes is the main reason to value LIFO. This is not a trivial point: a whole industry is built on it (see e.g. Mossack Fonseca). A company will continue to have inventory as long as it continues to operate. And so if COGS continues to rise, closing out the tax liability may be deferred indefinitely. This is a significant tax advantage and shareholders expect companies to maximize profits by any means. Accordingly, earnings management in order to minimize taxes is rational and expected. That said, earnings management is popular even if there is no economic rationale.

The question as to why companies do it, is different from why regulators allow it. As you have noted, IFRS rules do not allow LIFO. Uniquely, GAAP standards originated when the SEC spurred the private sector to set standards for themselves. Clearly, companies had a stake in minimizing taxes, and some may even operate their inventories as LIFO. This explains why the business practice is allowed under GAAP. Finally, it should be noted that, although this situation is far from ideal, it is very common that corporate accounts do not reflect the flow of goods very well. This is largely a result of complexity (i.e. large companies operating in multiple countries) as well as tax minimization efforts.

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  • $\begingroup$ Stunning. The SEC told companies to regulate themselves, so they created a set of standards which explicitly and legally allowed them to go on using unfair and indefensible practices. I think someone needs to tell the SEC to straighten itself out. – Infinite Page Fault – System halted $\endgroup$ – user7706 Jun 14 '16 at 17:54

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