Last in first out

What Is Last In, First Out (LIFO)?

Last In, First Out (LIFO) is an inventory valuation method used in financial accounting where the most recently purchased or produced goods are assumed to be the first ones sold. This method falls under the broader category of inventory management and cost flow assumptions. LIFO directly impacts a company's reported cost of goods sold (COGS) and the value of its ending inventory.

In an inflationary environment, where costs generally rise over time, LIFO typically results in a higher COGS and a lower reported net income compared to other inventory methods. This can lead to lower taxable income, making LIFO an attractive choice for tax purposes for many businesses. Conversely, in a deflationary environment, LIFO would yield a lower COGS and higher net income.

History and Origin

The Last In, First Out (LIFO) inventory method gained significant traction in the United States, particularly after it was recognized for tax purposes. Congress first approved the use of LIFO in the 1938 and 1939 Revenue Acts.³¹ This legislative endorsement came during a period when businesses, especially those in industries with fluctuating prices like petroleum refining and metals, sought methods to stabilize income and tax payments.³⁰

A key development in LIFO's history is the "LIFO conformity rule," introduced in 1939.²⁹ This rule mandates that if a company elects to use LIFO for tax purposes, it must also use it for financial reporting purposes to shareholders and for credit purposes.²⁸,²⁷ The Internal Revenue Service (IRS) established this rule to prevent businesses from manipulating their taxable income by using one inventory valuation method for tax purposes and another for financial reporting.²⁶ The LIFO conformity rule has played a crucial role in shaping the adoption and continued use of the LIFO method in the U.S.²⁵

Key Takeaways

• LIFO is an inventory accounting method that assumes the latest goods purchased are the first ones sold.
• In periods of rising costs, LIFO results in a higher cost of goods sold and lower reported net income, which can lead to tax savings.
• The LIFO conformity rule requires companies to use LIFO for both tax and financial reporting if they choose it for tax purposes.
• LIFO can lead to an inventory valuation on the balance sheet that does not reflect current market values, as older, lower-cost inventory remains.
• The International Financial Reporting Standards (IFRS) generally prohibit the use of LIFO.

Formula and Calculation

The Last In, First Out (LIFO) method calculates the cost of goods sold (COGS) by assuming that the most recently acquired inventory items are the first ones to be expensed. The ending inventory under LIFO is then comprised of the oldest costs.

To calculate COGS using LIFO:

1. Identify the number of units sold.
2. Determine the cost of the most recent units purchased, working backward until all units sold are accounted for.

The formula for Cost of Goods Sold remains standard, but the specific costs assigned to "goods available for sale" are where LIFO's assumption comes into play.

When applying LIFO, the "Purchases" component is crucial, as the costs associated with the most recent purchases are prioritized for COGS. Conversely, the "Ending Inventory" will consist of the costs from the earliest purchases. The determination of ending inventory directly influences the calculated COGS. This method contrasts with other inventory valuation techniques that use different cost flow assumptions.

Interpreting the LIFO Method

Interpreting the Last In, First Out (LIFO) method primarily involves understanding its impact on a company's financial statements, particularly the income statement and balance sheet. In an inflationary environment, where the cost of inventory is generally increasing, LIFO will assign the higher, most recent costs to the cost of goods sold (COGS). This results in a higher COGS and, consequently, a lower reported gross profit and net income. While this may make a company appear less profitable on paper, it often translates to a lower taxable income and thus reduced tax liabilities.²⁴,²³

However, the LIFO method can also lead to a balance sheet that shows inventory valued at significantly older, lower costs, which may not accurately reflect the current market value of the inventory on hand. This discrepancy, often tracked as a "LIFO reserve," can make it challenging for analysts to compare companies that use LIFO with those that employ other inventory methods, such as First In, First Out (FIFO).

Hypothetical Example

Consider a small electronics retailer, "TechGadgets," that sells a popular gaming console. Let's assume the following purchases and sales for the month of June:

• June 5: Purchased 10 consoles at $300 each.
• June 12: Purchased 15 consoles at $310 each.
• June 20: Sold 18 consoles.
• June 25: Purchased 12 consoles at $320 each.

To calculate the Cost of Goods Sold (COGS) using the Last In, First Out (LIFO) method for the 18 consoles sold on June 20:

1. Identify the most recent purchases first:

   • The most recent purchase before the sale was on June 12: 15 consoles at $310 each.
   • Cost from June 12 purchase: (15 \text{ consoles} \times $310/\text{console} = $4,650)

2. Determine remaining units needed:

   • TechGadgets sold 18 consoles, and 15 were accounted for from the June 12 purchase.
   • Remaining units to account for: (18 - 15 = 3 \text{ consoles})

3. Go to the next most recent purchase:

   • The next most recent purchase before the sale was on June 5: 10 consoles at $300 each.
   • Cost from June 5 purchase (for the remaining 3 units): (3 \text{ consoles} \times $300/\text{console} = $900)

4. Calculate total LIFO COGS:

   • Total COGS = Cost from June 12 purchase + Cost from June 5 purchase
   • Total COGS = ($4,650 + $900 = $5,550)

After the sale, the remaining inventory (ending inventory) would consist of the remaining 7 consoles from the June 5 purchase ((10 - 3 = 7)) at $300 each. The purchase on June 25 at $320 each would also be part of the ending inventory, as they were purchased after the sale. This example illustrates how the LIFO method directly affects the calculation of a company's cost of goods and the valuation of its remaining stock.

Practical Applications

The Last In, First Out (LIFO) method finds its most significant practical applications in industries with high inventory turnover and rising costs, particularly in the United States, due to its tax implications. Companies dealing with products where the most recently acquired units are physically sold first or where the cost of new inventory consistently increases often consider LIFO.

Key areas of application include:

• Tax Planning: During periods of inflation, LIFO generally results in a higher cost of goods sold, which leads to a lower reported net income and, consequently, reduced tax liabilities.²²,²¹ This tax advantage is a primary reason for its adoption by many U.S. companies. The Internal Revenue Service (IRS) regulations, specifically the LIFO conformity rule, require that if a company uses LIFO for tax purposes, it must also use it for financial reporting.²⁰,¹⁹
• Inventory-Heavy Industries: Industries such as automotive dealerships, retailers of durable goods, and companies dealing with commodities like oil and gas, which often experience rising inventory costs, may find LIFO advantageous for tax deferral.
• Financial Reporting Considerations: While LIFO can offer tax benefits, it can also lead to a balance sheet that shows inventory valued at older, potentially significantly lower costs. This can result in a "LIFO reserve," which represents the difference between inventory valued at LIFO and what it would be under a different method like FIFO. This reserve can be a key point for financial analysts trying to understand a company's true inventory value and profitability. Companies must comply with IRS regulations regarding the adoption and ongoing use of the LIFO method.¹⁸

Limitations and Criticisms

Despite its tax advantages, the Last In, First Out (LIFO) inventory method faces several significant limitations and criticisms. One of the primary drawbacks is that LIFO often does not reflect the actual physical flow of goods for many businesses. For instance, companies dealing with perishable goods or those employing a strict "first-in, first-out" inventory rotation system for quality control would find LIFO's assumption unrealistic.¹⁷

Another major criticism revolves around its impact on financial reporting. In an inflationary environment, LIFO can lead to a significant understatement of inventory on the balance sheet. Since the oldest, lowest costs remain in ending inventory, the reported inventory value may be substantially lower than its current replacement cost. This can distort financial ratios that rely on inventory figures and make comparisons between companies using LIFO and those using other methods challenging.¹⁶ The "LIFO reserve" is often disclosed to bridge this gap, but it still requires additional analysis.¹⁵

Furthermore, LIFO can lead to a situation known as "LIFO liquidation." If inventory levels decline, a company may be forced to "dip into" older, lower-cost LIFO layers, which can result in a significantly lower cost of goods sold and a higher reported profit for that period. This can trigger a higher tax liability on what is sometimes referred to as "phantom income," as it doesn't represent actual economic gains from current operations.¹⁴,¹³

Globally, LIFO is not universally accepted. The International Financial Reporting Standards (IFRS), used by most countries outside the United States, prohibit the use of LIFO. This lack of international acceptance creates a barrier for multinational corporations that need to reconcile their financial statements between U.S. Generally Accepted Accounting Principles (GAAP) and IFRS.¹²,¹¹ Critics argue that LIFO prioritizes tax benefits over a more faithful representation of a company's financial position and operational reality.¹⁰ A detailed academic review on the arguments for and against repealing the LIFO accounting choice can be found in scholarly discussions regarding inventory accounting.⁹

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

The core difference between Last In, First Out (LIFO) and First In, First Out (FIFO) lies in their assumptions about the flow of inventory costs, which significantly impacts a company's financial statements, particularly the income statement and balance sheet. Both are cost flow assumptions, not necessarily reflections of the physical movement of goods.

During periods of rising prices (inflation), LIFO leads to a higher cost of goods sold because the most expensive, recently acquired inventory is assumed to be sold first. This results in a lower reported gross profit and net income, which can reduce a company's tax liability.⁸ Conversely, FIFO assumes the oldest, typically cheaper, inventory is sold first, leading to a lower COGS, higher reported net income, and potentially higher taxes during inflation.⁷

For financial reporting, FIFO generally presents a balance sheet where inventory values are closer to their current market prices. In contrast, LIFO can result in inventory being valued at very old, historical costs, creating a significant difference between the book value and the current replacement cost of inventory. This difference is known as the LIFO reserve. The choice between LIFO and FIFO has substantial implications for a company's financial metrics and tax planning strategies.

FAQs

What types of businesses typically use LIFO?

Businesses that often use Last In, First Out (LIFO) are those with high inventory turnover and consistently rising inventory costs, especially in the United States due to the method's tax advantages. This includes industries like automotive, heavy machinery, petroleum, and certain types of retail where newer inventory is often sold before older stock, or where the tax benefits outweigh the potential balance sheet distortions.

How does LIFO affect a company's profitability?

In an inflationary environment, LIFO typically results in a higher cost of goods sold, which reduces the company's reported gross profit and net income. This means that LIFO makes a company appear less profitable on its income statement compared to other inventory methods like FIFO during periods of rising costs. However, this lower reported income also translates to lower taxable income and, consequently, lower tax payments.⁶,⁵

Is LIFO allowed internationally?

No, Last In, First Out (LIFO) is generally not permitted under International Financial Reporting Standards (IFRS), which are used by the majority of countries worldwide. IFRS requires companies to use either the First In, First Out (FIFO) method or the weighted-average cost method for inventory valuation. This global divergence in accounting standards means that multinational companies often need to convert their financial statements from U.S. GAAP (which allows LIFO) to IFRS for international reporting purposes.

What is the LIFO conformity rule?

The LIFO conformity rule is a U.S. tax regulation that mandates a company using the Last In, First Out (LIFO) method for tax purposes must also use it for its financial reporting to shareholders, partners, or other proprietors, and for credit purposes.⁴ This rule, enforced by the IRS, aims to prevent businesses from using LIFO to minimize taxable income while simultaneously presenting higher profits to investors under a different inventory method.³

Does LIFO benefit companies during inflation?

Yes, LIFO can benefit companies during periods of inflation. When prices are rising, the most recently purchased inventory is also the most expensive. Under LIFO, these higher costs are expensed first as part of the cost of goods sold, which results in a higher COGS. A higher COGS, in turn, leads to a lower reported net income and a reduced tax obligation. This tax deferral is a significant advantage for companies using LIFO in an inflationary environment.²,¹