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What Is Last In, First Out (LIFO)?

Last In, First Out (LIFO) is an inventory accounting method that assumes the most recently acquired or produced items in a company's inventory accounting are the first ones sold or expensed. This approach impacts a company's financial reporting by influencing the calculation of the Cost of Goods Sold (COGS) and the valuation of remaining inventory. LIFO falls under the broader financial category of inventory valuation and is a key choice companies make when determining how to allocate costs. Unlike methods that might reflect the physical flow of goods, LIFO is a cost flow assumption that primarily affects financial statements and tax liabilities, particularly during periods of inflation.

History and Origin

The LIFO method was introduced and gained acceptance for U.S. accounting and tax purposes primarily during the 1930s, a period marked by economic challenges and price fluctuations. It emerged as an evolution of an earlier concept known as the "base stock method," where a certain quantity of inventory was considered a permanent investment carried at historical cost.⁶⁷ Early proponents of LIFO included petroleum refiners and metals companies, with the American Petroleum Institute recommending its use in 1934.⁶⁶ Congress formally approved the use of LIFO in the 1938 and 1939 Revenue Acts.⁶⁵ A significant development was the introduction of the "LIFO conformity rule" within the 1939 Revenue Act, which required companies electing LIFO for tax purposes to also use it for financial reporting.⁶⁴ The history of LIFO illustrates the intricate relationship between taxation and the evolution of generally accepted accounting principles in the United States.⁶³

Key Takeaways

• LIFO assumes that the last units purchased are the first ones sold, impacting the Cost of Goods Sold and inventory valuation.
• During inflationary periods, LIFO generally results in a higher Cost of Goods Sold and lower taxable income.⁶¹, ⁶²
• LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP) but is prohibited by International Financial Reporting Standards (IFRS).⁶⁰
• The LIFO conformity rule requires companies using LIFO for tax purposes to also use it for their primary financial statements.⁵⁸, ⁵⁹
• The use of LIFO can lead to an older, potentially understated, valuation of remaining inventory on the balance sheet.⁵⁶, ⁵⁷

Formula and Calculation

The core of LIFO calculation involves determining the Cost of Goods Sold (COGS) by assigning the cost of the most recent inventory purchases to the units sold. The remaining inventory is then valued using the costs of the oldest purchases.

To calculate COGS using the LIFO method:

And to calculate Ending Inventory (EI) using LIFO:

Where:

• Units Sold from Latest Purchase: The quantity of goods sold that are assumed to come from the most recent inventory layer.
• Cost of Latest Purchase: The per-unit cost of the most recent inventory acquisition.
• Remaining Units from Earliest Purchase: The quantity of goods remaining in inventory that are assumed to come from the oldest inventory layer.
• Cost of Earliest Purchase: The per-unit cost of the earliest inventory acquisition.

Companies often use a layering approach, tracking inventory costs by the order in which they were acquired.⁵⁵ The LIFO reserve represents the difference between a company's inventory value under LIFO and what it would be under the First In, First Out (FIFO) method.

Interpreting the Last In, First Out (LIFO) Method

Interpreting financial statements prepared using the LIFO method requires an understanding of its impact on key financial metrics. In an inflationary environment, LIFO typically results in a higher Cost of Goods Sold because the most recent, often higher, costs are expensed first. This leads to a lower gross profit and net income compared to other inventory valuation methods.⁵⁴ While this may make a company appear less profitable on its income statement, it also results in lower taxable income, which can provide tax benefits.⁵², ⁵³

Conversely, the ending inventory value on the balance sheet under LIFO will be lower during periods of rising prices, as it retains older, lower costs.⁵¹ This can lead to an inventory valuation that may not accurately reflect current market values.⁵⁰ Analysts and investors often consider the LIFO reserve, which is disclosed by companies, to understand the difference in inventory and profitability had a different method, such as FIFO, been used.⁴⁹

Hypothetical Example

Consider a company, "Gadget Corp.," that sells a single type of electronic gadget. Here's their inventory data for July:

• Beginning Inventory (July 1): 100 units @ $100 each
• Purchase 1 (July 10): 150 units @ $110 each
• Purchase 2 (July 20): 200 units @ $120 each
• Units Sold during July: 300 units

Using the LIFO method, Gadget Corp. assumes the 300 units sold came from the most recent purchases:

1. From Purchase 2 (July 20): All 200 units @ $120 = $24,000
2. From Purchase 1 (July 10): Remaining 100 units needed (300 total sold - 200 from P2) @ $110 = $11,000

Therefore, the Cost of Goods Sold (COGS) for July would be:
( $24,000 + $11,000 = $35,000 )

The ending inventory would consist of the oldest units:

• Remaining from Purchase 1: 50 units @ $110 = $5,500
• From Beginning Inventory: 100 units @ $100 = $10,000

Total Ending Inventory = $5,500 + $10,000 = $15,500.

This example illustrates how LIFO assigns higher, more recent costs to the units sold, resulting in a higher COGS and leaving older, lower costs in the ending inventory, especially in an inflationary environment where costs are rising.

Practical Applications

LIFO is applied primarily within the United States, as it is permitted under U.S. GAAP. Its practical applications are often seen in industries where inventory costs are subject to frequent fluctuations or general inflation. Companies with large, undifferentiated inventories, such as steel producers, oil and gas companies, and some retailers (like auto dealerships), may find LIFO advantageous.⁴⁷, ⁴⁸

One of the primary reasons businesses choose LIFO is for potential tax benefits during periods of rising prices. By matching the most recent, higher costs of inventory against current revenues, LIFO generally leads to a higher Cost of Goods Sold.⁴⁶ This results in a lower reported net income and, consequently, a reduced taxable income and lower tax liabilities.⁴⁴, ⁴⁵ This can improve a company's cash flow by deferring tax payments.⁴³

Furthermore, LIFO can help companies more accurately reflect current replacement costs in their Cost of Goods Sold, providing a conservative view of profitability during inflationary times.⁴² This can be a part of a broader risk management strategy to mitigate the impact of price volatility on reported earnings.⁴¹

Limitations and Criticisms

Despite its potential tax advantages, the Last In, First Out (LIFO) method faces several significant limitations and criticisms. One of the primary concerns is that LIFO often does not reflect the actual physical flow of goods, particularly for businesses that manage inventory on a "first-in, first-out" basis (e.g., perishable goods).³⁹, ⁴⁰ This can lead to an inaccurate representation of a company's true inventory costs and movements.³⁸

A major criticism of LIFO is its impact on the balance sheet. Since LIFO assumes the most recently purchased items are sold first, older, potentially outdated costs are left to value the remaining inventory.³⁷ During periods of sustained inflation, this results in an understatement of inventory value on the balance sheet, which may not accurately reflect the current market value of the company's assets.³⁶ This can distort financial ratios and may make the company appear less liquid or less valuable to investors and creditors.³⁴, ³⁵

Furthermore, LIFO is prohibited under International Financial Reporting Standards (IFRS), which are used in many countries worldwide.³³ This creates complexities for multinational companies that must adhere to different accounting standards across jurisdictions, often requiring them to convert their financial statements from LIFO to FIFO or weighted average cost for international reporting purposes.³² IFRS prohibits LIFO due to concerns about comparability across companies and the potential for earnings manipulation, particularly during "LIFO liquidations" where old, low-cost inventory layers are sold, artificially inflating profits.³¹

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

LIFO and First In, First Out (FIFO) are two distinct inventory accounting methods that determine how costs are assigned to goods sold and remaining inventory. The fundamental difference lies in their assumptions about which units are sold first.

Confusion between the two methods often arises because LIFO's cost flow assumption typically does not align with the physical flow of most goods. While a grocery store would physically sell the oldest milk first (FIFO), a company using LIFO for accounting purposes would assume the cost of the newest milk was expensed first, even if it's still on the shelf.¹⁰ The choice between LIFO and FIFO significantly impacts a company's financial statements and its tax obligations.

FAQs

1. Why do companies use LIFO?

Companies primarily use LIFO in the U.S. to gain tax advantages during periods of rising prices or inflation. By expensing the most recent, typically higher, inventory costs through the Cost of Goods Sold, LIFO results in lower reported net income and, consequently, lower taxable income and tax liabilities.⁸, ⁹

2. Is LIFO allowed everywhere?

No, LIFO is not allowed everywhere. It is permitted under U.S. Generally Accepted Accounting Principles (GAAP) but is prohibited by International Financial Reporting Standards (IFRS), which are adopted by many countries globally.⁷

3. What is the LIFO conformity rule?

The LIFO conformity rule, enforced by the U.S. Internal Revenue Service (IRS), mandates that if a company uses the LIFO method for tax reporting, it must also use it for its primary financial statements issued to shareholders and for credit purposes.⁵, ⁶ This rule prevents companies from reporting lower profits for tax purposes while presenting higher profits to investors.⁴

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

LIFO typically results in a lower valuation of inventory on the balance sheet compared to other methods, especially during inflationary periods. This is because the older, lower-cost inventory layers are assumed to remain on the books.³ Companies using LIFO must disclose the LIFO reserve, which highlights the difference between their LIFO inventory value and what it would be under FIFO.

5. Does LIFO always lead to lower taxes?

LIFO generally leads to lower taxes in an inflationary environment because it results in a higher Cost of Goods Sold and thus lower taxable income.² However, in a deflationary period where prices are falling, LIFO would result in a lower Cost of Goods Sold and a higher taxable income, potentially leading to higher taxes.¹