What Is Last-In, First-Out (LIFO)?
Last-In, First-Out (LIFO) is an inventory accounting method where the most recently acquired or produced items are assumed to be the first ones sold. This accounting method directly impacts a company's reported Cost of Goods Sold (COGS) and the valuation of its remaining inventory on the Balance Sheet. LIFO is a key component of inventory accounting within the broader field of financial accounting, influencing a company's Income Statement and ultimately its financial statements.
History and Origin
The Last-In, First-Out (LIFO) method gained prominence in the United States, particularly during periods of rising prices. While inventory costing methods had long existed, LIFO was formally recognized for U.S. tax purposes in the late 1930s. Its adoption was influenced by economic conditions, specifically the desire for companies to match current costs with current revenues, which could reduce taxable income during inflationary periods. The ability to use LIFO for tax purposes became contingent on its use for financial reporting, a requirement known as the LIFO conformity rule. Guidance and regulations for LIFO are extensively detailed by bodies such as the Internal Revenue Service (IRS). For instance, the IRS Internal Revenue Manual outlines specific requirements for maintaining LIFO inventory records to support financial reporting and tax computations.4
Key Takeaways
- LIFO assumes the last units purchased are the first ones sold, impacting COGS and ending inventory valuation.
- In periods of inflation, LIFO generally results in a higher COGS and lower reported gross profit and taxable income.
- The LIFO method is permitted under U.S. Generally Accepted Accounting Principles (GAAP) but is prohibited under International Financial Reporting Standards (IFRS).
- Companies choosing LIFO must adhere to specific IRS conformity rules, generally requiring the method's use for both tax and financial reporting.
- LIFO can lead to a significant difference between the reported inventory value on the balance sheet and the actual current cost of inventory.
Formula and Calculation
The calculation of Cost of Goods Sold (COGS) and ending inventory under LIFO involves tracking the specific cost layers of inventory purchases. When goods are sold, the costs from the most recent purchases are expensed first until that layer is depleted, then moving to the next most recent layer.
Cost of Goods Sold (COGS) using LIFO:
Ending Inventory (EI) using LIFO:
Where:
- "Units Sold from Most Recent Layers" refers to the quantities of goods sold, matched with the costs of the latest inventory purchases.
- "Cost per Unit in Layer" is the cost at which those specific units were acquired.
- "Units Remaining from Oldest Layers" refers to the quantities of goods still in stock, matched with the costs of the earliest inventory purchases.
This method directly affects the calculation of a company's profit and its overall financial statements.
Interpreting the LIFO
Interpreting financial results from a company using LIFO requires understanding its impact on profitability and asset valuation. During periods of rising costs, LIFO reports a higher Cost of Goods Sold (COGS) because it matches the most expensive, most recent inventory costs against current revenues. This leads to a lower reported gross profit and, consequently, lower taxable income. While this can result in tax savings for the company, it also means the inventory value remaining on the Balance Sheet is based on older, lower costs, potentially understating the true current value of the assets. Conversely, in a period of deflation, LIFO would report lower COGS and higher profits, as older, more expensive inventory costs would be matched to current revenue.
Hypothetical Example
Consider a hypothetical company, "GadgetCo," which sells a single type of electronic gadget.
Inventory Purchases:
- January 1: 100 units @ $100 per unit
- February 15: 150 units @ $110 per unit
- March 10: 80 units @ $120 per unit
Sales during the Quarter:
- Total sales: 250 units
Under the LIFO method, GadgetCo assumes that the 250 units sold came from the most recent purchases first:
- From March 10 purchase: 80 units @ $120 = $9,600
- From February 15 purchase: 150 units @ $110 = $16,500
- Remaining units needed (250 - 80 - 150 = 20) from January 1 purchase: 20 units @ $100 = $2,000
LIFO Calculation:
- Cost of Goods Sold (COGS): $9,600 (March) + $16,500 (February) + $2,000 (January) = $28,100
- Ending Inventory: The remaining inventory would be from the oldest layers.
- January 1 purchase: 100 units - 20 units sold = 80 units @ $100 = $8,000
Thus, GadgetCo's Income Statement would show a COGS of $28,100, and its Balance Sheet would report ending inventory of $8,000.
Practical Applications
The Last-In, First-Out (LIFO) method has distinct practical applications, primarily related to its impact on financial reporting and taxation. In the United States, companies often choose LIFO during periods of inflation because it allows them to expense the higher, more recent costs against revenue, resulting in a higher Cost of Goods Sold (COGS). This leads to a lower reported taxable income and, consequently, lower income tax payments. This tax benefit is a significant driver for LIFO adoption, particularly for businesses with substantial inventory holdings like manufacturing or retail.
However, companies must adhere to the LIFO conformity rule, which generally mandates that if LIFO is used for tax purposes, it must also be used for financial reporting to shareholders. Despite this, supplemental disclosures of non-LIFO information are permitted, provided they are clearly labeled as such.3 The Financial Accounting Standards Board (FASB) provides guidance through its Accounting Standards Codification (ASC) on inventory valuation. For instance, while ASU 2015-11 simplified inventory measurement for companies using FIFO or average cost by requiring valuation at the lower of cost and Net Realizable Value, it specifically excluded LIFO from these changes, highlighting LIFO's unique treatment under Generally Accepted Accounting Principles (GAAP).2
Limitations and Criticisms
Despite its tax advantages during inflation, the Last-In, First-Out (LIFO) method faces several limitations and criticisms. A primary concern is that LIFO can distort the value of inventory reported on the Balance Sheet. Because it assumes the oldest costs remain in inventory, the reported inventory value can significantly understate the current market value of a company's stock, especially after prolonged periods of inflation. This can make the balance sheet appear less robust than it actually is, impacting metrics such as working capital.
Another major criticism is that LIFO is prohibited under International Financial Reporting Standards (IFRS), meaning multinational companies operating under both GAAP and IFRS must reconcile their inventory accounting or use a different method. The International Accounting Standards Board (IASB) eliminated LIFO due to its perceived lack of "representational faithfulness" regarding the actual physical flow of goods. Critics also argue that LIFO can allow for earnings manipulation. If inventory levels fluctuate, particularly through LIFO liquidations (selling more units than purchased in a period, thus dipping into older, lower-cost inventory layers), it can result in artificially inflated gross profit and taxable income in certain periods. An analysis on LIFO adoption and inflation notes that while LIFO provides tax benefits, it can complicate financial analysis for external parties who may not fully understand its implications or normalize its effects.1 Additionally, calculating and maintaining the LIFO reserve, which tracks the difference between LIFO inventory cost and what it would be under FIFO, can be complex and time-consuming, potentially leading to errors in financial reporting.
Last-In, First-Out (LIFO) vs. First-In, First-Out (FIFO)
Last-In, First-Out (LIFO) and First-In, First-Out (FIFO) are two common inventory costing methods, but they assume different flows of goods, leading to distinct impacts on financial statements. LIFO assumes that the most recently purchased inventory items are the first ones sold. This generally results in a higher Cost of Goods Sold (COGS) and lower ending inventory value during periods of rising prices (inflation). Conversely, FIFO assumes that the first items purchased are the first ones sold. This leads to a lower COGS and a higher ending inventory value during inflationary periods because older, lower costs are expensed first. In a period of deflation, the effects are reversed: LIFO would show a lower COGS and higher ending inventory, while FIFO would show a higher COGS and lower ending inventory. The choice between LIFO and FIFO significantly impacts a company's reported gross profit and taxable income.
FAQs
What is the primary benefit of using LIFO?
The primary benefit of using LIFO, especially during periods of inflation, is the reduction in taxable income. By expensing the most recent, higher costs, LIFO results in a higher Cost of Goods Sold (COGS), which lowers reported profits and, consequently, the amount of income tax a company owes.
Is LIFO allowed internationally?
No, LIFO is generally not permitted under International Financial Reporting Standards (IFRS). Most countries outside the United States follow IFRS, meaning LIFO is rarely used for financial reporting globally. This creates a significant difference in how inventory is valued and how profits are reported between U.S. GAAP and IFRS.
How does LIFO affect a company's balance sheet?
Under LIFO, the inventory remaining on the Balance Sheet is valued based on the oldest costs. During inflationary periods, this means the reported inventory value can be significantly lower than the current replacement cost of those items. This can lead to an understatement of assets and potentially impact financial ratios such as working capital.
Can a company switch from LIFO to another inventory method?
Yes, a company can switch from LIFO to another inventory method, such as FIFO or the average cost method. However, changing an accounting method requires approval from the IRS for tax purposes and typically involves a significant adjustment to prior period financial statements to reflect the change.
What is the LIFO reserve?
The LIFO reserve is a contra-asset account that represents the difference between the inventory value calculated using LIFO and what it would be under the First-In, First-Out (FIFO) method. Companies using LIFO often disclose this reserve, allowing financial analysts to adjust financial statements to a FIFO basis for comparability.