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 valuation method used in cost accounting that assumes the most recently purchased or produced goods are the first ones sold. This accounting principle directly impacts a company's financial statements, particularly the Income Statement and Balance Sheet, by influencing the calculation of Cost of Goods Sold (COGS) and the value of remaining inventory. The LIFO method is one of several acceptable ways for businesses to account for their inventory under Generally Accepted Accounting Principles (GAAP) in the United States.

History and Origin

The Last-In, First-Out (LIFO) inventory valuation method emerged in the United States during the 1930s, a period marked by economic volatility and inflationary pressures. It gained traction as businesses sought ways to better match current costs with current revenues, particularly when prices were rising. Early proponents included petroleum refiners and metals companies. The American Petroleum Institute recommended its use in 1934. Congress officially approved the use of LIFO for tax purposes through the Revenue Acts of 1938 and 1939.²⁴, ²⁵ The 1939 Revenue Act also introduced the "LIFO conformity rule," which requires companies electing LIFO for tax purposes to also use it for financial reporting.²², ²³ This rule significantly influenced its widespread adoption in the U.S.

Key Takeaways

LIFO assumes that the most recently acquired inventory items are sold first.
In periods of inflation, LIFO typically results in a higher Cost of Goods Sold and lower Taxable Income.
The use of LIFO is permitted under U.S. GAAP but is prohibited under International Financial Reporting Standards (IFRS).
LIFO can lead to an older, potentially outdated, valuation of remaining inventory on the balance sheet.
Companies using LIFO are required to disclose their LIFO Reserve, which quantifies the difference between LIFO inventory valuation and what it would be under another method.

Formula and Calculation

The LIFO method does not rely on a single, universally applied formula like a simple average. Instead, it is a cost flow assumption that dictates which costs are expensed. To calculate Cost of Goods Sold (COGS) and ending inventory using LIFO, a business tracks the cost of each inventory layer.

The calculation for COGS under LIFO involves taking the cost of the most recent purchases until the total units sold are accounted for. The remaining inventory is then valued using the costs of the oldest purchased units.

For example, if a company sells (X) units, the COGS calculation would effectively be:

[
\text{COGS}_{\text{LIFO}} = \sum (\text{Units Sold from Most Recent Purchase Layers} \times \text{Cost per Unit in Layer})
]

And the Ending Inventory would be:

[
\text{Ending Inventory}_{\text{LIFO}} = \sum (\text{Remaining Units from Oldest Purchase Layers} \times \text{Cost per Unit in Layer})
]

Where:

Units Sold from Most Recent Purchase Layers: The quantity of items sold, drawing first from the latest inventory acquisitions.
Cost per Unit in Layer: The unit cost associated with each specific purchase batch or layer.
Remaining Units from Oldest Purchase Layers: The quantity of items not sold, which are assumed to be from the earliest inventory acquisitions.

This method directly influences the reported Net Income and the carrying value of inventory on the balance sheet.

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

Interpreting the LIFO method primarily revolves around its impact on a company's financial results, especially during periods of changing costs. When prices for goods are rising, LIFO matches higher, more recent costs against current revenues, resulting in a higher Cost of Goods Sold (COGS) and, consequently, lower reported Gross Profit and taxable income. This can lead to tax savings in an inflationary environment.²⁰, ²¹ Conversely, during periods of declining prices (deflation), LIFO would result in a lower COGS and higher reported profits.¹⁹

The value of ending inventory under LIFO tends to be understated on the Balance Sheet during inflationary periods because it assumes that the oldest, lower-cost items are still in stock. This can affect Financial Ratios that use inventory figures, such as the inventory turnover ratio and working capital ratios, making comparisons with companies using other methods challenging.¹⁷, ¹⁸ Analysts often consider the LIFO Reserve to gain a more complete picture of the current value of inventory.

Hypothetical Example

Consider "Gadget Co.," a retailer selling a single type of gadget.

Beginning Inventory (January 1): 100 units @ $10 each = $1,000

Purchases:

February 10: 150 units @ $12 each = $1,800
March 20: 200 units @ $15 each = $3,000

Sales (April): Gadget Co. sells 280 units.

Using the LIFO method, the 280 units sold are assumed to come from the latest purchases first:

From March 20 purchase: 200 units @ $15 = $3,000
Remaining units needed: 280 - 200 = 80 units
From February 10 purchase: 80 units @ $12 = $960

Calculation of Cost of Goods Sold (COGS):
COGS = $3,000 (from March) + $960 (from February) = $3,960

Calculation of Ending Inventory:
The remaining units would be from the oldest stock:

From February 10 purchase: 150 - 80 = 70 units @ $12 = $840
From January 1 beginning inventory: 100 units @ $10 = $1,000
Ending Inventory = $840 (from February) + $1,000 (from January) = $1,840

In this example, the LIFO method assigns the higher, more recent costs to the units sold, resulting in a higher Cost of Goods Sold and a lower reported profit for Gadget Co. The inventory remaining on the books is valued at the older, lower costs.

Practical Applications

The LIFO method is primarily used by companies in the United States, particularly those operating in industries with high inventory turnover and frequently rising costs, such as retail, automotive, and petroleum.¹⁶ Its most significant practical application stems from the potential tax advantages it offers during periods of inflation. By assigning the most recent, often higher, costs to the Cost of Goods Sold, LIFO results in a lower reported Taxable Income and, consequently, lower tax liabilities.¹⁴, ¹⁵ This benefit can lead to improved Cash Flow for the business.¹², ¹³

For companies subject to U.S. Generally Accepted Accounting Principles (GAAP), using LIFO for tax purposes generally requires its use for financial reporting as well, a requirement known as the LIFO conformity rule.¹⁰, ¹¹ The Securities and Exchange Commission (SEC) oversees financial disclosures for publicly traded companies in the U.S., and while LIFO is permitted, the SEC emphasizes clear disclosure regarding inventory valuation policies and their impact on financial results.

Limitations and Criticisms

Despite its tax benefits in inflationary environments, the LIFO method faces several significant limitations and criticisms, particularly concerning its impact on the accuracy and comparability of financial statements.

One major criticism is that LIFO can result in an inventory value on the Balance Sheet that does not reflect current market prices, as older, lower costs remain in the inventory account. This can distort the true financial picture of a company's assets, especially over extended periods of inflation when the difference between LIFO and current costs (the LIFO Reserve) can become substantial.⁹ This outdated inventory valuation can also negatively affect Financial Ratios related to liquidity and asset management.⁷, ⁸

Another contentious point is the potential for "LIFO liquidation." This occurs when a company sells more inventory than it purchases, leading it to "dip into" older, lower-cost inventory layers. While this can temporarily inflate reported Gross Profit and Net Income, it may not accurately reflect current business performance and is generally unsustainable.⁶

A primary reason for the declining use of LIFO globally is its prohibition under International Financial Reporting Standards (IFRS). The International Accounting Standards Board (IASB) eliminated LIFO in 2003 with the revision of IAS 2 Inventories, citing its lack of representational faithfulness of actual inventory flows and concerns about potential earnings manipulation and reduced comparability across companies. The IASB concluded that tax considerations, while a driver for LIFO use, do not provide an adequate conceptual basis for selecting an appropriate accounting treatment.

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

LIFO and First-In, First-Out (FIFO) are two prominent inventory valuation methods that differ in their assumptions about the flow of goods and, consequently, their impact on a company's financial statements.

Feature	Last-In, First-Out (LIFO)	First-In, First-Out (FIFO)
Cost Flow Assumption	Assumes the most recently acquired goods are sold first.	Assumes the oldest acquired goods are sold first.
Cost of Goods Sold (COGS) in Inflation	Higher (matches current, higher costs with revenue)	Lower (matches older, lower costs with revenue)
Ending Inventory in Inflation	Lower (oldest, lower costs remain on Balance Sheet)	Higher (recent, higher costs remain on Balance Sheet)
Net Income in Inflation	Lower (due to higher COGS)	Higher (due to lower COGS)
Tax Implications in Inflation	Lower Taxable Income and tax liabilities	Higher Taxable Income and tax liabilities
Global Acceptance	Allowed primarily under U.S. Generally Accepted Accounting Principles (GAAP)	Permitted globally under U.S. GAAP and International Financial Reporting Standards (IFRS)

The primary point of confusion often arises during periods of inflation. LIFO users prefer it because it matches the more recent, higher costs with current revenues, which can result in lower reported Net Income and, therefore, lower tax obligations. FIFO, on the other hand, is generally seen as providing a more accurate representation of the physical flow of goods for most businesses, as oldest items are typically sold first to avoid obsolescence.

FAQs

What is the main purpose of using the LIFO method?

The main purpose of using the LIFO (Last-In, First-Out) method is often to minimize taxable income during periods of inflation. By expensing the most recent, and usually highest, costs first, a company can report a higher Cost of Goods Sold and thus a lower net income.

Is LIFO allowed in all countries?

No, LIFO is not allowed in all countries. While it is permitted under U.S. Generally Accepted Accounting Principles (GAAP), it is explicitly prohibited under International Financial Reporting Standards (IFRS), which are used in many other countries globally.⁵

How does LIFO affect a company's cash flow?

During inflationary periods, LIFO typically results in a higher Cost of Goods Sold and a lower reported profit. This lower profit leads to reduced taxable income and, consequently, lower tax payments. The reduction in tax payments can lead to an improvement in a company's Cash Flow.³, ⁴

What is the LIFO Reserve?

The LIFO Reserve is a contra-asset account that represents the difference between the inventory value calculated using LIFO and the inventory value if another method, typically FIFO, had been used. Companies using LIFO are required to disclose this reserve in the footnotes to their financial statements, allowing users to adjust for comparability.¹, ²