Last in, first out lifo

What Is Last-In, First-Out (LIFO)?

Last-In, First-Out (LIFO) is an inventory valuation method under financial accounting that assumes the most recently purchased inventory items are the first ones sold. This method falls under the broader category of inventory management and is primarily used by businesses to calculate their cost of goods sold (COGS) and the value of their remaining inventory. In periods of rising prices, LIFO generally results in a higher COGS and lower taxable income, which can lead to tax savings for businesses.³⁷ Conversely, it results in a lower reported net income compared to other methods like First-In, First-Out (FIFO).³⁶

History and Origin

The Last-In, First-Out (LIFO) method gained traction in the United States in the late 1930s. Its adoption was largely influenced by the period of substantial inflation occurring at the time, which led to businesses facing higher tax liabilities on purchased goods that had not yet been sold.³⁵ Industry trade organizations and the American Institute of Certified Public Accountants (AICPA) lobbied Congress to support LIFO, advocating for its ability to provide a more accurate reflection of income by matching current costs against current revenues.³⁴ These efforts led to the enactment of legislation in 1938 and subsequent approval by Congress in 1939, authorizing taxpayers to value inventories using LIFO for federal income tax purposes.³³,³² Historically, LIFO can be seen as an evolution of the "base stock method," an older inventory accounting approach.³¹

Key Takeaways

• LIFO assumes that the most recent inventory purchases are the first ones sold.
• It is an inventory valuation method used for both financial accounting and tax purposes.³⁰
• In periods of rising costs, LIFO results in a higher Cost of Goods Sold and lower taxable income.²⁹
• LIFO is permitted under U.S. Generally Accepted Accounting Principles (US GAAP) but is prohibited under International Financial Reporting Standards (IFRS).²⁸,²⁷

Formula and Calculation

The calculation of Cost of Goods Sold (COGS) under the LIFO method involves identifying the cost of the most recently acquired inventory units that correspond to the number of units sold. The remaining inventory is then valued at the cost of the oldest units still on hand.

While there isn't a single universal "LIFO formula," the process typically follows these steps:

1. Identify units sold: Determine the number of units that were sold during the accounting period.
2. Assign costs: Starting with the most recent purchases, assign their costs to the units sold until the total number of units sold is accounted for.
3. Calculate COGS: Sum the costs assigned in step 2 to arrive at the Cost of Goods Sold.
4. Calculate Ending Inventory: The remaining units in inventory are then valued at the cost of the earliest purchases that have not yet been "sold" under the LIFO assumption.

For example, if a company has:

• Beginning Inventory: 100 units @ $10 each
• Purchase 1: 50 units @ $12 each
• Purchase 2: 70 units @ $13 each

And sells 180 units:

Under LIFO, the 180 units sold would be assumed to come from:

• 70 units from Purchase 2 @ $13 = $910
• 50 units from Purchase 1 @ $12 = $600
• 60 units from Beginning Inventory @ $10 = $600

Therefore, the Cost of Goods Sold would be $910 + $600 + $600 = $2,110.

The ending inventory would then consist of the remaining 40 units from the beginning inventory, valued at $10 each, totaling $400.

This approach directly impacts a company's profitability metrics on its financial statements.

Interpreting the Last-In, First-Out (LIFO)

Interpreting the LIFO inventory method primarily involves understanding its impact on a company's financial statements, particularly in periods of changing inventory costs. When prices are rising, LIFO leads to a higher Cost of Goods Sold (COGS) because it matches the most expensive, most recently acquired inventory with current revenues.²⁶ This results in lower reported gross profit and, consequently, lower taxable income.²⁵ For investors and analysts, this means that a company using LIFO during inflationary periods will show a lower net income on its income statement and a lower inventory value on its balance sheet compared to a company using FIFO.²⁴

Conversely, in periods of declining prices, LIFO would result in a lower COGS and higher reported net income, as it would match the most recently purchased (and now cheaper) inventory with revenues. The "LIFO reserve" is a key metric to consider; it represents the difference between the inventory value reported under LIFO and what it would have been under FIFO.²³ This reserve helps users of financial statements understand the cumulative impact of LIFO on a company's reported inventory and earnings.

Hypothetical Example

Consider "GadgetCorp," an electronics retailer. Let's trace their inventory using LIFO:

• January 1: GadgetCorp has 100 units of "SuperGadget X" in stock, purchased at $50 each.
• February 15: GadgetCorp purchases another 150 units of SuperGadget X at $55 each.
• March 10: GadgetCorp sells 120 units of SuperGadget X to customers.

To calculate the Cost of Goods Sold (COGS) using LIFO for the March 10 sale:

1. Identify units sold: 120 units.
2. Start with the last-in (most recent) purchases:
   • The 120 units sold are assumed to come from the February 15 purchase (150 units at $55).
   • So, 120 units * $55/unit = $6,600.

Therefore, GadgetCorp's COGS for this sale under LIFO is $6,600.

Now, let's look at the remaining inventory after the sale:

• Of the 150 units purchased on February 15, 120 were "sold." This leaves 30 units (150 - 120) from that purchase, still valued at $55 each.
• The original 100 units from January 1, purchased at $50 each, remain untouched.

So, GadgetCorp's ending inventory would be:

• 30 units @ $55 = $1,650
• 100 units @ $50 = $5,000

Total Ending Inventory = $1,650 + $5,000 = $6,650.

This example illustrates how LIFO directly impacts the valuation of inventory assets and the calculation of COGS.

Practical Applications

The Last-In, First-Out (LIFO) inventory method finds its primary applications in situations where businesses aim to optimize their tax liabilities, particularly in environments of rising costs. Companies in industries with high inventory turnover, such as retail and manufacturing, might consider LIFO.²²

One key practical application of LIFO is its potential for tax deferral. During periods of inflation, when the cost of acquiring inventory is increasing, LIFO matches the more expensive, recently purchased goods against current revenues.²¹ This results in a higher Cost of Goods Sold and, consequently, a lower taxable income, leading to reduced current tax payments.²⁰ This can provide a significant cash flow advantage to businesses.

However, it is important to note that the Internal Revenue Service (IRS) imposes a "LIFO conformity rule," which mandates that if a company uses LIFO for tax purposes, it must also use LIFO for its financial reporting to shareholders.¹⁹,¹⁸ This means that while companies may benefit from lower tax payments, their reported financial earnings to the public will also appear lower. This trade-off between tax benefits and reported profitability is a critical consideration for companies evaluating inventory accounting methods.¹⁷

Limitations and Criticisms

Despite its potential tax benefits, the Last-In, First-Out (LIFO) inventory method faces several limitations and criticisms, primarily concerning its impact on financial reporting and its lack of international acceptance.

One major criticism is that LIFO often does not reflect the actual physical flow of goods for many businesses. In most operational settings, companies typically sell their oldest inventory first to avoid obsolescence or spoilage, which aligns more closely with the First-In, First-Out (FIFO) method. This mismatch between the accounting assumption and the actual flow can distort the reported financial performance.

Another significant limitation is that LIFO is prohibited under International Financial Reporting Standards (IFRS), the accounting standards used by over 144 countries globally.¹⁶ This means that multinational corporations or companies seeking to raise capital in international markets may face challenges in comparing their financial statements if they use LIFO for their U.S. operations. The lack of global accounting standards conformity can hinder financial transparency and comparability across borders.¹⁵ For companies that may eventually need to transition from US GAAP to IFRS, the elimination of LIFO can trigger a "LIFO recapture" event, which results in additional taxable income as the inventory is revalued from LIFO to FIFO.¹⁴

Furthermore, in a period of sustained inflation, LIFO can lead to an artificially low valuation of ending inventory on the balance sheet. This is because the oldest, and likely cheapest, inventory costs remain on the books, which may not accurately represent the current economic value of the inventory. This can make a company's asset valuation appear understated.

Last-In, First-Out (LIFO) vs. First-In, First-Out (FIFO)

Last-In, First-Out (LIFO) and First-In, First-Out (FIFO) are two prominent inventory valuation methods that impact how a company reports its cost of goods sold and the value of its remaining inventory. The fundamental difference lies in their assumptions about which inventory units are sold first.

The choice between LIFO and FIFO significantly influences a company's financial statements, affecting profitability, asset valuation, and tax liabilities, especially in periods of inflation or deflation. Businesses select an inventory method based on various factors, including industry practices, tax considerations, and financial reporting objectives.

FAQs

Why do companies use LIFO?

Companies primarily use LIFO for potential tax benefits, especially in periods of rising prices. By assuming the most recently purchased (and often most expensive) inventory is sold first, LIFO results in a higher Cost of Goods Sold, which leads to lower reported taxable income and, consequently, reduced tax payments.⁴

Is LIFO allowed by all accounting standards?

No, LIFO is not allowed by all accounting standards. While it is permitted under U.S. Generally Accepted Accounting Principles (US GAAP), it is generally prohibited under International Financial Reporting Standards (IFRS), which are used in many other countries worldwide.³

How does LIFO affect a company's balance sheet?

Under LIFO, in an inflationary environment, the inventory reported on the balance sheet will be valued at older, lower costs. This results in a lower inventory asset value compared to what it would be under FIFO. This can make the company's asset base appear smaller than its actual current replacement cost.

Can a company switch from LIFO to another inventory method?

Yes, a company can switch from LIFO to another inventory method, but it is considered a change in accounting method and typically requires approval from the Internal Revenue Service (IRS).² Such a change can also trigger a "LIFO recapture" amount, which is the difference between the inventory value under FIFO and LIFO, leading to additional taxable income that must be recognized.¹

What industries commonly use LIFO?

Industries that often deal with large volumes of inventory and where costs tend to rise over time, such as retail, automotive, and petroleum, have historically been more inclined to use LIFO. However, any business with significant inventory can potentially use LIFO if it meets the necessary accounting and tax requirements.