What Is LIFO?
LIFO, an acronym for Last-In, First-Out, is an inventory valuation method used in accounting. It operates on the assumption that the most recently acquired or produced items are the first ones sold or expensed. This means that when a company sells goods, the Cost of Goods Sold (COGS) is calculated using the cost of the newest inventory, while older, potentially lower-cost inventory, remains on the Balance Sheet as unsold Inventory. LIFO is primarily permitted under U.S. GAAP (Generally Accepted Accounting Principles) and falls under the broader financial category of inventory valuation.47, 48
History and Origin
The LIFO inventory valuation method gained prominence in the United States, particularly during periods of Inflation. Its legislative acceptance for tax purposes in the U.S. dates back to the Revenue Acts of 1938 and 1939, as an outgrowth of earlier accounting concepts like the "base stock method."45, 46 The ability to use LIFO for tax reporting purposes has been a key driver of its adoption and continued use in the U.S.44 For instance, the Internal Revenue Service (IRS) outlines acceptable accounting methods, including LIFO, in its official publications, such as IRS Publication 538.43
Key Takeaways
- LIFO (Last-In, First-Out) is an inventory valuation method where the most recent costs are expensed first.42
- It is primarily used in the United States and permitted under U.S. GAAP.
- During periods of rising costs (inflation), LIFO typically results in a higher Cost of Goods Sold and lower Taxable Income.41
- IFRS (International Financial Reporting Standards), used by most other countries, generally prohibits the use of LIFO due to concerns about financial statement comparability and potential distortions.39, 40
- LIFO can affect a company's financial statements, including its Income Statement and Balance Sheet.37, 38
Formula and Calculation
Calculating the Cost of Goods Sold (COGS) under the LIFO method involves identifying the cost of the most recently purchased inventory units. The formula is applied by assuming that the last units bought are the first ones sold.
To calculate COGS using LIFO:
- Identify the number of units sold during the period.
- Determine the cost of the most recent inventory purchases.
- Allocate the cost of the units sold, starting with the latest purchases and working backward until all units sold are accounted for.
For example, if a company sells 100 units and its most recent purchases were 60 units at $15 each and prior to that 80 units at $12 each, the LIFO COGS would be calculated by taking the 60 units at $15 and then 40 units (100-60) from the next most recent batch at $12.34, 35, 36
The formula can be represented as:
The remaining inventory on the balance sheet would then be valued using the costs of the oldest inventory layers.
Interpreting the LIFO
Interpreting the LIFO method largely depends on the prevailing economic conditions, particularly inflation or deflation. In an inflationary environment, where costs of goods are rising, LIFO results in a higher Cost of Goods Sold because the most expensive, most recent inventory costs are expensed first.33 This leads to a lower reported Gross Profit and Net Income, which can, in turn, result in lower taxable income.31, 32 Conversely, during periods of deflation, where costs are falling, LIFO would yield a lower Cost of Goods Sold and a higher reported net income. The method impacts the valuation of inventory on the balance sheet, as the remaining inventory is valued at older, potentially lower, costs.30
Hypothetical Example
Consider a small electronics retailer, "TechGadgets," which sells a popular model of wireless headphones. TechGadgets made the following purchases in June:
- June 5: 100 units at $50 per unit
- June 15: 150 units at $55 per unit
- June 25: 80 units at $60 per unit
By the end of June, TechGadgets sold 200 units of these headphones. To calculate the Cost of Goods Sold using the LIFO method:
- The last units in were from the June 25th purchase: 80 units @ $60.
- Cost: 80 units * $60/unit = $4,800
- Remaining units sold (200 total sold - 80 from June 25) = 120 units.
- The next most recent units were from the June 15th purchase: 150 units at $55. TechGadgets needs 120 of these.
- Cost: 120 units * $55/unit = $6,600
Therefore, the total LIFO Cost of Goods Sold for June is:
$4,800 (from June 25) + $6,600 (from June 15) = $11,400.
The remaining inventory of 130 units (150 - 120 = 30 from June 15; all 100 from June 5) would be valued at $50 per unit for the 100 oldest units and $55 for the remaining 30 units, reflecting the older costs.
Practical Applications
The LIFO method finds practical application primarily within the United States, largely due to its potential tax advantages during periods of rising costs.29 Businesses, especially those with large inventories where physical flow doesn't strictly adhere to FIFO (First-In, First-Out), such as certain retailers or industrial equipment suppliers, may opt for LIFO to minimize their taxable income during inflationary times.28 By matching the most recent, often higher, costs against current revenues, LIFO helps reduce reported profits and, consequently, tax liabilities.27 This approach has been a subject of ongoing discussion in U.S. tax policy.25, 26
Limitations and Criticisms
Despite its tax benefits for U.S. companies, LIFO faces significant limitations and criticisms, particularly from an accounting standards perspective. A major critique is that LIFO can result in an inventory valuation on the Balance Sheet that does not reflect current market values, especially during prolonged periods of inflation, as older, lower costs remain in ending inventory.23, 24 This can distort a company's financial position, potentially making its working capital appear worse than it is.22
Furthermore, LIFO is widely prohibited under IFRS (International Financial Reporting Standards), which are used by most countries globally.20, 21 The IFRS Foundation's IAS 2 (Inventories) standard specifically mandates the use of FIFO or weighted-average cost formulas, citing concerns about comparability of Financial Statements and the potential for earnings manipulation.17, 18, 19 For instance, IFRS aims for financial statements to reflect current economic conditions, which LIFO often fails to achieve.16 Critics also point to the complexity of maintaining LIFO records and the possibility of "LIFO liquidation," where a reduction in inventory levels can cause older, lower-cost inventory to be expensed, artificially inflating profits.15 The Council on Foreign Relations has discussed LIFO as a "tax loophole" given its effect on lowering taxable income for some U.S. firms.14
LIFO vs. FIFO
The primary difference between LIFO (Last-In, First-Out) and FIFO (First-In, First-Out) lies in their assumptions about the flow of inventory costs. LIFO assumes that the most recently purchased or produced goods are sold first, meaning that the latest costs are expensed as Cost of Goods Sold. Conversely, FIFO assumes that the oldest inventory items are sold first, thus expensing the earliest costs.13
These differing assumptions lead to distinct impacts on a company's financial statements. In an inflationary environment, LIFO generally results in a higher Cost of Goods Sold and a lower Net Income, which can lead to lower taxable income.11, 12 FIFO, during inflation, would result in a lower Cost of Goods Sold and a higher net income, reflecting the lower, older costs.10 Regarding the balance sheet, LIFO leaves older, potentially understated, costs in ending inventory during inflation, while FIFO's ending inventory more closely reflects current market values.9 Many jurisdictions outside the U.S. mandate FIFO or weighted-average methods, with IFRS explicitly prohibiting LIFO.8
FAQs
Why do companies use LIFO?
Companies in the U.S. often use LIFO primarily for tax advantages during periods of inflation. By expensing the most recently acquired, and typically higher, costs, LIFO results in a higher Cost of Goods Sold and a lower reported Taxable Income, which can lead to lower income tax payments.6, 7
Is LIFO allowed internationally?
No, LIFO is generally not allowed under IFRS (International Financial Reporting Standards), which are used in most countries outside the United States.5 IFRS mandates the use of either FIFO or the weighted-average cost method for inventory valuation.3, 4
How does LIFO affect a company's balance sheet?
Under LIFO, especially during inflationary periods, the value of ending inventory on the Balance Sheet is based on the oldest costs.2 This can lead to an understatement of the actual current value of a company's inventory, as it does not reflect the most recent purchase prices.1