Lifo

What Is LIFO?

LIFO, an acronym for "Last-In, First-Out," is an inventory accounting method used to determine the cost of goods sold (COGS) and the value of remaining inventory at the end of an accounting period. Under the LIFO method, it is assumed that the most recently purchased or produced goods are the first ones sold, meaning their costs are expensed first. This approach is part of the broader field of accounting methods and has significant implications for a company's financial statements and tax obligations.

History and Origin

The Last-In, First-Out (LIFO) inventory method gained prominence in the United States, particularly during periods of rising prices. Its origins can be traced back to the 1930s when companies, especially those dealing with commodities like petroleum, metals, and leather, sought methods to mitigate the impact of price fluctuations on their reported income³⁸,³⁷. The American Petroleum Institute, for instance, advocated for its use in 1934³⁶.

LIFO was initially an outgrowth of an earlier accounting technique known as the "base stock method." The push for LIFO's acceptance for tax purposes intensified, leading to its eventual approval by Congress in the Revenue Acts of 1938 and 1939³⁵,³⁴. A critical development was the "LIFO conformity rule," enacted by the U.S. Internal Revenue Service (IRS), which mandates that companies choosing to use LIFO for tax reporting must also use it for financial reporting purposes³³. This rule, outlined in documents such as IRS Publication 538, has shaped the application of LIFO in the U.S..

Key Takeaways

• LIFO (Last-In, First-Out) is an inventory valuation method where the most recent costs are expensed first as cost of goods sold.
• It is permitted under Generally Accepted Accounting Principles (GAAP) in the United States but is prohibited under International Financial Reporting Standards (IFRS).,³²
• In periods of inflation, LIFO generally results in a higher COGS, lower taxable income, and reduced tax liabilities.³¹,³⁰
• LIFO can lead to older, lower costs remaining on the balance sheet for inventory, potentially distorting its current value.²⁹
• The "LIFO conformity rule" requires companies to use LIFO for both tax and financial reporting if they choose this method.²⁸

Formula and Calculation

The LIFO method does not rely on a single, universally applied formula like a financial ratio. Instead, it is a cost flow assumption applied when calculating the cost of goods sold (COGS) and ending inventory. The core principle is that the cost of the most recently acquired items is used first for sales, working backward through inventory layers.

To calculate COGS using LIFO, you identify the units sold and assign them the costs of the latest purchases until those units are exhausted, then move to the next most recent purchases. The remaining units in inventory are then valued at the costs of the oldest purchases.

The basic accounting equation for inventory costing methods, which LIFO influences, is:

[
\text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory} = \text{Cost of Goods Sold (COGS)}
]

Here:

• Beginning Inventory: The value of inventory at the start of the accounting period.
• Purchases: The cost of new inventory acquired during the period.
• Ending Inventory: The value of inventory remaining at the end of the period, determined using the LIFO assumption.
• Cost of Goods Sold (COGS): The expense directly associated with the production or acquisition of goods sold during the period, calculated using the LIFO assumption.

Interpreting the LIFO

Interpreting the LIFO method requires an understanding of its impact on a company's financial reporting. When prices for inventory are rising, LIFO assumes that the more expensive, most recently acquired goods are sold first. This results in a higher cost of goods sold on the income statement. A higher COGS, in turn, leads to a lower reported gross profit and, consequently, a lower net income and taxable income²⁷,²⁶. This can be a significant advantage during inflationary periods, as it reduces a company's tax burden²⁵,²⁴.

Conversely, in a period of falling prices, LIFO would result in a lower COGS and thus a higher reported net income, leading to higher taxes²³. Companies using LIFO often maintain a "LIFO reserve," which is the difference between the inventory value under LIFO and what it would be under the First-In, First-Out (FIFO) method. This reserve provides insight into the deferred tax liability associated with using LIFO.

Hypothetical Example

Consider "GadgetCorp," a company that sells electronic components. On January 1, GadgetCorp has a beginning inventory of 100 units at a cost of $10 per unit.

During January, GadgetCorp makes the following purchases:

• January 10: 200 units at $12 per unit
• January 20: 150 units at $15 per unit

By the end of January, GadgetCorp sells 300 units. To calculate the cost of goods sold (COGS) using the LIFO method:

1. Identify the most recent purchases first. GadgetCorp sold 300 units. Under LIFO, the costs are assigned starting with the last units purchased.

   • The first 150 units sold are from the January 20 purchase: 150 units * $15/unit = $2,250.
   • Remaining units to account for: 300 - 150 = 150 units.
   • These 150 units are taken from the January 10 purchase: 150 units * $12/unit = $1,800.

2. Calculate Total COGS.

   • Total COGS (LIFO) = $2,250 (from Jan 20) + $1,800 (from Jan 10) = $4,050.

3. Calculate Ending Inventory.

   • Of the January 10 purchase (200 units), 150 units were sold. So, 50 units remain at $12/unit = $600.
   • The beginning inventory (100 units) remains untouched at $10/unit = $1,000.
   • Total Ending Inventory (LIFO) = $600 + $1,000 = $1,600.

In this scenario, the LIFO method assigns the highest costs to COGS, leading to a lower reported gross profit and, consequently, a lower taxable income compared to other methods if prices are rising.

Practical Applications

LIFO is primarily used in industries where inventory items are indistinguishable, or where the most recent costs are considered to best match current revenues. Common sectors that have historically utilized LIFO include manufacturers, distributors, and retailers dealing with non-perishable goods, such as automotive dealerships, and those in the metals or petroleum industries²²,²¹,²⁰.

One of the most significant practical applications of LIFO is its potential for taxable income reduction during periods of inflation,¹⁹. By expensing the higher, more recent costs of inventory, a company's cost of goods sold (COGS) increases, which in turn lowers reported net income and, consequently, the amount of income subject to taxation¹⁸. This can lead to increased cash flow as a result of lower tax payments, allowing businesses to retain more capital for reinvestment or operational needs¹⁷,¹⁶.

However, the continued use of LIFO in the U.S. is a subject of ongoing debate. For example, some lawmakers have proposed repealing LIFO for specific industries, such as oil and gas, as a way to raise federal revenue¹⁵. Despite such proposals, LIFO remains an accepted accounting method under Generally Accepted Accounting Principles (GAAP) in the U.S.

Limitations and Criticisms

Despite its potential tax advantages, the LIFO inventory method faces several significant limitations and criticisms. A primary concern is that LIFO can result in an inventory valuation on the balance sheet that does not reflect current market prices. Because the oldest costs remain in inventory, these values can become outdated and significantly understated, particularly during prolonged periods of inflation¹⁴,. This can distort a company's true financial picture, making the balance sheet less informative to external users.

Another major criticism stems from the fact that LIFO is prohibited under International Financial Reporting Standards (IFRS), which are used in many countries worldwide. The International Accounting Standards Board (IASB) prohibits LIFO because it can lead to distortions in a company's profitability and financial statements,¹³. This divergence between Generally Accepted Accounting Principles (GAAP) (U.S.) and IFRS creates challenges for multinational companies and comparability for global investors.

Furthermore, LIFO can lead to a phenomenon known as "LIFO liquidation." This occurs when a company sells more units than it purchases in a period, dipping into older, lower-cost LIFO layers that have been sitting in inventory. During times of rising prices, this can artificially inflate reported net income and gross profit because very low historical costs are matched against current revenues. While it may temporarily boost earnings, it is often unsustainable and can signal operational issues or a deliberate attempt to manipulate earnings. Investors often need to scrutinize the footnotes of financial reporting to identify LIFO liquidations.

The tax benefits of LIFO can also be less significant in environments with lower corporate tax rates, diminishing one of its primary appeals¹². The complexity of managing LIFO layers and the potential for distorted financial reporting are ongoing critiques of the method.

LIFO vs. FIFO

LIFO and FIFO (First-In, First-Out) are two fundamental inventory accounting methods that differ in their assumptions about which inventory costs are expensed first.

• LIFO (Last-In, First-Out) assumes that the most recently purchased goods are the first ones sold. Consequently, the cost of goods sold (COGS) reflects the most current costs, while the remaining inventory on the balance sheet consists of older, potentially lower costs,¹¹. In an inflationary environment, LIFO typically results in a higher COGS and lower taxable income, leading to lower tax payments¹⁰,. However, this can make the reported inventory value on the balance sheet appear artificially low compared to current market prices⁹.

• FIFO (First-In, First-Out) assumes that the oldest purchased goods are the first ones sold. This means that the COGS reflects older, typically lower costs, and the remaining inventory is valued at the most recent costs,⁸. In an inflationary environment, FIFO generally leads to a lower COGS, higher reported gross profit, and higher net income, which can make a company appear more profitable⁷,. However, this also usually translates to a higher tax liability⁶. FIFO is often considered more reflective of the actual physical flow of goods for many businesses, particularly those with perishable items,.

The choice between LIFO and FIFO significantly impacts a company's financial statements, including its profitability and cash flow due to differing tax implications⁵,.

FAQs

What types of businesses typically use LIFO?

Businesses that often use LIFO are those with high-value, non-perishable inventory or those whose inventory costs tend to rise over time, such as retailers, automotive dealerships, and companies in the metals and petroleum industries⁴,³. The goal is often to reduce taxable income during periods of inflation.

Can a company switch between LIFO and FIFO freely?

In the United States, companies can switch between LIFO and FIFO. However, changing accounting methods generally requires approval from the IRS and may have specific rules regarding how the change impacts previous financial periods,². Once a change is made, companies are usually locked into the new method for a certain period.

How does LIFO affect a company's balance sheet?

Under LIFO, the inventory reported on the balance sheet often reflects older, lower costs because the most recent (and typically more expensive) goods are assumed to have been sold first¹. In an inflationary environment, this can lead to an understatement of the current market value of the remaining inventory assets.