Overall, LIFO accounting methods can help a firm actually reduce taxes by marking that the most expensive inventory has been sold first. The way that this helps reduce taxes is because prices are going to get higher over time. One problem, however, with LIFO accounting is that it doesn't actually track the real flow of items that are indistinguishable from each other. For this reason, LIFO accounting methods are not allowed in the United Kingdom.

The United States does allow LIFO accounting practices, and does so under a different kind of accounting philosophy. The US GAAP believes that inflation is not the only source of a company's economic profit. The belief is that because owners of firms are always having to replace inventory with higher priced inventory (due to inflation), then LIFO accounting is a better way to match current revenue and current cost. Using LIFO accounting is also a way to defer paying taxes, so that you aren't paying taxes on inflation-based income that you don't yet have.

If you would like to use LIFO accounting practices so that you can defer your tax payments by also waiting to recognize profits, you can file IRS Form 970 to ask for permission from the IRS.

So are there any problems with using LIFO accounting practices?

One potential problem that you will have to look out for is LIFO liquidation. What happens in LIFO liquidation is that if new inventory is not brought in, for whatever reason, like a search or desire for more profit, then the older inventory will be sold and eventually liquidated. You run into problems because the older inventory had a lower cost, due to inflation. When the older inventory is liquidated, then the net income will be higher than if new inventory was liquidated. This means that as the owner you will have to pay higher taxes. You have effectively subverted your intentions to pay less taxes and defer your tax payments.

The United States has what is known as the LIFO Conformity Rule. This rule states that LIFO accounting can only be used for the purpose of tax deferment. This means that you, as a business owner, cannot use LIFO accounting to report your finances.

How does LIFO accounting affect you as an investor? This is an important question that not too many investors take the time to investigate. A company or firm's inventory usually makes up the largest portion of that company's assets. If you are trying to evaluate and analyze stocks, then you need to understand how a company's assets, and thus its inventory, is analyzed.

Essentially, the way that inventory is evaluated is with the following formula:

Beginning Inventory + Net Purchases - Cost of Goods Sold = Ending Inventory

With LIFO accounting, the last unit that is put in the inventory, or the most expensive unit (due to inflation and rising costs) is the first one that's sold. The older inventory is used to decide what the ending inventory is. LIFO accounting ends up declaring a lower net income, and is used because for tax benefits rather than income benefits. Ultimately, you should know whether or not a company is using LIFO accounting, because it's not going to give you an accurate representation of the financial state of the company, only how much income they're paying taxes on.