Last in, first out lifo: Meaning, Criticisms & Real-World Uses

What Is Last In, First Out (LIFO)?

Last In, First Out (LIFO) is an inventory accounting method, falling under the broader category of inventory accounting in financial management. This method assumes that the most recently acquired or produced items are the first ones sold or expensed. Consequently, the cost of goods sold (COGS) reflects the cost of the latest inventory purchases, while older, potentially lower-cost inventory remains on the balance sheet as ending inventory. LIFO contrasts with other accounting methods like First In, First Out (FIFO) and the weighted-average cost method. The primary appeal of LIFO, particularly in periods of inflation, stems from its potential to reduce taxable income by matching higher, more recent costs against current revenues.

History and Origin

The LIFO inventory valuation method has been in use since the 1930s in the United States. Its adoption gained traction as businesses sought ways to better match current costs with current revenues, particularly in an economic environment where prices for goods and raw materials could fluctuate. While the concept of LIFO has existed for decades, its specific application and acceptance have largely been shaped by regulatory bodies. In the U.S., LIFO is permitted under Generally Accepted Accounting Principles (GAAP). However, globally, the International Financial Reporting Standards (IFRS) explicitly prohibits its use. The Internal Revenue Service (IRS) plays a significant role in governing LIFO in the U.S., requiring companies that use LIFO for tax purposes to also use it for financial reporting, a stipulation known as the LIFO conformity rule.¹¹,¹⁰

Key Takeaways

LIFO assumes the most recently purchased inventory items are sold first.
In periods of rising costs, LIFO generally results in a higher cost of goods sold and lower reported net income.
This lower reported net income can lead to reduced taxable income and, consequently, lower tax liabilities in an inflationary environment.
LIFO is permitted under U.S. GAAP but is prohibited under IFRS due to concerns about financial statement comparability and the potential for outdated inventory values on the balance sheet.
Companies using LIFO must adhere to the IRS's conformity rule, meaning they must use LIFO for both tax and financial reporting.

Formula and Calculation

The calculation for LIFO involves identifying the costs of the latest purchases to determine the cost of goods sold (COGS) and leaving the costs of the oldest purchases as ending inventory.

To calculate COGS using LIFO:

\text{COGS}_{\text{LIFO}} = \sum (\text{Units Sold from Latest Purchases} \times \text{Cost of Latest Purchases})

To calculate Ending Inventory using LIFO:

\text{Ending Inventory}_{\text{LIFO}} = \sum (\text{Units Remaining from Earliest Purchases} \times \text{Cost of Earliest Purchases})

Where:

Units Sold from Latest Purchases: The number of units sold, sourced from the most recent incoming inventory layers.
Cost of Latest Purchases: The per-unit cost of those most recent purchases.
Units Remaining from Earliest Purchases: The number of units of inventory left at the end of the period, representing the oldest incoming inventory layers.
Cost of Earliest Purchases: The per-unit cost of those oldest purchases.

Interpreting Last In, First Out (LIFO)

Interpreting the figures derived from the LIFO method requires understanding its impact on a company's financial statements and tax obligations. Under LIFO, in a period of rising prices (inflation), the cost of goods sold (COGS) will be higher because it accounts for the most recently acquired, and thus more expensive, inventory. This higher COGS results in a lower reported gross profit and, subsequently, lower taxable income.

Conversely, the ending inventory value reported on the balance sheet under LIFO will be lower. This is because the older, less expensive inventory costs are assumed to remain unsold. For financial analysis, it means that the balance sheet may not reflect the current economic value of the inventory, as it is composed of historical costs. Users of financial statements need to be aware of the inventory costing method used to properly compare companies or evaluate trends over time.

Hypothetical Example

Consider a small electronics retailer, "TechGadgets Inc.," that sells a popular smart home device.

Inventory Purchases:

January 10: 100 units @ $50 each
February 15: 150 units @ $55 each
March 20: 80 units @ $60 each

Sales:

During March, TechGadgets Inc. sells 200 units.

To calculate the cost of goods sold (COGS) and ending inventory using LIFO:

Step 1: Determine COGS using LIFO
Under LIFO, the last units in are the first units out. So, from the 200 units sold:

First, take all units from the most recent purchase (March 20): 80 units @ $60 = $4,800
Remaining units to account for from sales: 200 - 80 = 120 units
Next, take units from the second most recent purchase (February 15): 120 units @ $55 = $6,600
Total LIFO COGS = $4,800 + $6,600 = $11,400

Step 2: Determine Ending Inventory using LIFO
The remaining units are from the earliest purchases:

From January 10 purchase: 100 units - (150 units from February - 120 units sold from February) = 100 units @ $50 = $5,000 (after accounting for sales from later layers, the remaining 30 units from February are not part of ending inventory; the earliest 100 units are untouched).
Wait, let's re-calculate ending inventory carefully.
- Initial inventory: 100 units (Jan) + 150 units (Feb) + 80 units (Mar) = 330 units.
- Units sold: 200 units.
- Ending inventory units: 330 - 200 = 130 units.
Since 200 units were sold using LIFO:
- 80 units from March (all of it) are expensed.
- 120 units from February (out of 150) are expensed.
- This leaves 30 units from the February purchase (150 - 120 = 30) and all 100 units from the January purchase untouched in ending inventory.
Therefore, Ending Inventory:
- 30 units @ $55 (from February) = $1,650
- 100 units @ $50 (from January) = $5,000
- Total LIFO Ending Inventory = $1,650 + $5,000 = $6,650

In this example, TechGadgets Inc.'s cost of goods sold (COGS) would be $11,400, and its ending inventory would be valued at $6,650.

Practical Applications

Last In, First Out (LIFO) is predominantly used in the United States by businesses that deal with large volumes of inventory and where the cost of goods is generally increasing. Industries that often consider LIFO include manufacturers, distributors, retailers, and automobile dealerships.⁹, The primary practical application of LIFO lies in its potential to offer tax advantages during periods of inflation.

By assuming that the most recently purchased, and typically higher-cost, items are sold first, LIFO results in a higher cost of goods sold (COGS). This higher COGS reduces the company's reported gross profit and, consequently, its taxable income and income tax liability. This can lead to increased cash flow for the business, as less cash is paid out in taxes. For companies experiencing rising input costs, this can be a significant benefit in managing their profitability and liquidity. The Internal Revenue Service (IRS) requires companies electing LIFO for tax purposes to also use it for their financial statements provided to shareholders and for credit purposes, a rule known as the LIFO conformity rule.⁸

Limitations and Criticisms

Despite its tax benefits, Last In, First Out (LIFO) faces several significant limitations and criticisms, particularly from an accounting standards perspective. One of the most prominent criticisms is that LIFO can result in an inventory valuation on the balance sheet that does not reflect the current market value of the goods. Because older, lower costs remain in ending inventory, the reported inventory value can become outdated and obsolete, particularly in periods of prolonged inflation.,⁷ This can make the balance sheet less reliable for assessing the true economic value of a company's assets.

Another major criticism is the potential for earnings manipulation through "LIFO liquidations." If a company significantly reduces its inventory levels, it may be forced to sell off older, lower-cost inventory layers, leading to an artificially inflated gross profit and net income in that period. Such liquidations can distort the company's true profitability and are often unsustainable.

Furthermore, LIFO's limited global acceptance is a major drawback for multinational corporations. The International Financial Reporting Standards (IFRS), used by most countries worldwide, explicitly prohibits the use of LIFO.⁶,⁵ This prohibition stems from concerns over the method's potential to distort financial statements and hinder comparability across international borders. Companies operating under both U.S. Generally Accepted Accounting Principles (GAAP) and IFRS must maintain different inventory records, adding complexity and cost to their 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 prominent inventory accounting methods used to determine the cost of goods sold (COGS) and ending inventory value. The fundamental difference lies in their assumptions about the flow of inventory.

Feature	Last In, First Out (LIFO)	First In, First Out (FIFO)
Cost Flow Assumption	Assumes the most recent costs are expensed first.	Assumes the oldest costs are expensed first.
COGS in Rising Prices	Higher (reflects more recent, higher costs).	Lower (reflects older, lower costs).
Ending Inventory in Rising Prices	Lower (consists of older, lower costs).	Higher (consists of more recent, higher costs).
Net Income in Rising Prices	Lower (due to higher COGS), leading to lower taxable income.	Higher (due to lower COGS), leading to higher taxable income.
Balance Sheet Accuracy	May show outdated inventory values.	Generally reflects more current inventory values.
Global Acceptance	Primarily used in the U.S. under GAAP.	Widely accepted globally under both GAAP and IFRS.
Physical Flow Match	Rarely matches the actual physical flow of goods.	Often matches the actual physical flow of goods for perishable items.

The choice between LIFO and FIFO significantly impacts a company's financial statements, particularly the income statement and balance sheet, affecting reported profitability and tax liabilities. Companies typically choose LIFO for the tax benefits during periods of inflation, while FIFO is often preferred for its clear reflection of current inventory values.

FAQs

1. Why do companies use LIFO?

Companies primarily use LIFO to reduce their taxable income during periods of inflation. By assuming the most expensive, recently acquired inventory is sold first, LIFO results in a higher cost of goods sold (COGS), which lowers reported net income and, consequently, their tax burden.⁴,³

2. Is LIFO allowed everywhere?

No, LIFO is not allowed everywhere. While it is permitted in the United States under Generally Accepted Accounting Principles (GAAP), the International Financial Reporting Standards (IFRS), which are used in most other countries globally, explicitly prohibit its use.,

3. What is the LIFO conformity rule?

The LIFO conformity rule, enforced by the IRS, states that if a company chooses to use the LIFO method for income tax purposes, it must also use LIFO for its external financial reporting, such as reports issued to shareholders or for credit purposes.² This rule prevents companies from reporting high profits to investors while simultaneously reporting low profits for tax minimization.

4. How does LIFO impact a company's balance sheet?

LIFO typically results in a lower inventory value on the balance sheet compared to other methods like FIFO, especially in an inflationary environment. This is because the older, less expensive costs of inventory are assumed to remain unsold, leading to an asset value that may not reflect current market prices.¹