Lifo accounting

What Is LIFO Accounting?

LIFO accounting, standing for Last-In, First-Out, is an inventory valuation method within the broader field of financial accounting. This method assumes that the most recently purchased or produced inventory items are the first ones sold or used. Consequently, the cost of these newer items is recognized as the cost of goods sold (COGS), while the older inventory costs remain on the balance sheet as ending inventory.

In periods of rising prices or inflation, LIFO accounting typically results in a higher COGS and, therefore, a lower reported net income on the income statement. This can lead to a lower taxable income and reduced tax liability for businesses, making it an attractive choice for tax purposes in the United States.

History and Origin

The Last-In, First-Out (LIFO) accounting method emerged in the United States during the 1930s. Its development was largely driven by industries with significant inventory holdings, such as petroleum refiners and metals companies, who sought a method that would better match current costs with current revenues, especially during periods of price fluctuations. The American Petroleum Institute recommended its use in 1934, and the American Institute of Accountants' Committee on Federal Taxation also favored its acceptance under specific conditions.¹⁸

LIFO accounting was first officially accepted into U.S. tax law with the Revenue Act of 1938 and more broadly with the 1939 Revenue Act.¹⁷,¹⁶,¹⁵ A key aspect of its adoption was the "LIFO conformity rule," mandated by Internal Revenue Code Section 472(c). This rule requires that if a company chooses to use LIFO for tax reporting to potentially lower its taxable income, it must also use LIFO for its external financial reporting to shareholders and creditors.¹⁴,¹³,¹² This conformity rule was introduced to prevent companies from manipulating inventory valuation to gain tax advantages while simultaneously presenting a higher profitability to investors.¹¹

Key Takeaways

• LIFO accounting assumes the most recently acquired inventory is sold first, affecting the calculation of Cost of Goods Sold and ending inventory.
• During inflationary periods, LIFO generally leads to a higher Cost of Goods Sold and lower reported net income, which can result in lower income tax.
• The U.S. LIFO conformity rule requires companies using LIFO for tax purposes to also use it for financial reporting.
• LIFO is not permitted under International Financial Reporting Standards (IFRS) due to concerns about it not reliably representing actual inventory flow and leading to an out-of-date balance sheet inventory value.
• Companies considering LIFO must assess its impact on financial metrics, tax obligations, and compliance with applicable accounting standards.

Formula and Calculation

LIFO accounting calculates the Cost of Goods Sold (COGS) and ending inventory based on the assumption that the last units purchased are the first ones sold. To determine COGS using LIFO, you take the cost of the most recent inventory purchases until the number of units sold is accounted for. For ending inventory, the remaining units are assumed to be from the oldest purchases.

The basic formula for Cost of Goods Sold applies regardless of the inventory costing method:

However, the values for "Purchases" and "Ending Inventory" under LIFO are determined by the cost flow assumption. For LIFO, the calculation of COGS prioritizes the most recent purchase costs. This impacts the gross profit and ultimately the company's revenue and profitability.

Interpreting the LIFO Accounting

Interpreting financial statements prepared using LIFO accounting requires an understanding of its underlying cost flow assumption. Since LIFO assumes the most recent costs are expensed first, it generally leads to a higher Cost of Goods Sold during periods of rising prices. This results in a lower reported net income compared to other methods like First-In, First-Out (FIFO) or the weighted-average method.

For analysts, this means that a company using LIFO might appear to have lower profitability than an otherwise identical company using FIFO during inflationary times. However, the lower reported income translates to lower taxable income, which can be a tax advantage in the U.S. It's crucial for stakeholders to consider the specific inventory valuation method used when comparing financial performance across different companies or over time for the same company. The effect of LIFO on the balance sheet is that the inventory remaining often reflects older, lower costs, which may not accurately represent the current replacement cost of the 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 15: 50 units @ $12 each = $600
• April 20: 75 units @ $14 each = $1,050
• June 10: 80 units @ $15 each = $1,200

Sales:

• During the year, Gadget Co. sells 200 units.

LIFO Accounting Calculation:

Under LIFO, the 200 units sold are assumed to be from the most recent purchases:

1. From June 10 purchase: 80 units @ $15 = $1,200
2. From April 20 purchase: 75 units @ $14 = $1,050
3. From February 15 purchase: 45 units @ $12 (to reach 200 total units sold) = $540

Cost of Goods Sold (COGS):

• $1,200 (June) + $1,050 (April) + $540 (February) = $2,790

Ending Inventory:
The remaining units are from the oldest layers:

• 5 units from February 15 purchase (50 - 45 sold) @ $12 = $60
• 100 units from Beginning Inventory @ $10 = $1,000

Total Ending Inventory: $1,060

In this hypothetical example, LIFO accounting resulted in a Cost of Goods Sold of $2,790 and an ending inventory of $1,060. This reflects the impact of assuming the most recent (and higher-priced, in this scenario) items were sold first.

Practical Applications

LIFO accounting is predominantly applied in the United States and is chosen by companies primarily for its potential tax benefits during periods of inflation. By expensing the most recent, typically higher, costs first, LIFO reduces reported taxable income, thereby lowering current corporate income taxes. This can be particularly appealing to businesses with significant inventory and a history of rising purchase costs.

Industries that often utilize LIFO include those with large, relatively homogeneous inventories and high inventory turnover, such as automotive dealerships, industrial equipment suppliers, and certain retail sectors. The Securities and Exchange Commission (SEC) provides guidance on various accounting standards, including those related to inventory. Companies must provide adequate disclosures regarding their inventory valuation methods in their financial statements, as detailed in SEC regulations.¹⁰,⁹ This ensures transparency for investors and allows them to understand how a company's reported performance is influenced by its chosen inventory method.

Limitations and Criticisms

While LIFO accounting offers potential tax advantages, it faces several limitations and criticisms, primarily concerning its impact on financial reporting transparency and comparability. One significant drawback is that, especially in inflationary environments, LIFO leaves older, often lower, costs in ending inventory on the balance sheet. This can result in an inventory value that is significantly understated and does not reflect the current market value or replacement cost of the goods on hand.⁸,⁷ Such a disparity can distort a company's financial position and make it difficult for investors to accurately assess the true value of its assets.

Another major criticism is that LIFO is prohibited under International Financial Reporting Standards (IFRS), the accounting standards used by over 140 countries worldwide.⁶,⁵,⁴ The International Accounting Standards Board (IASB) eliminated LIFO from IAS 2, Inventories, in 2003, arguing that it "is generally not a reliable representation of actual inventory flows" and that it results in inventory being recognized at amounts that bear little relationship to recent cost levels.³,²,¹ This global divergence creates complexities for multinational corporations that operate in both U.S. Generally Accepted Accounting Principles (GAAP) and IFRS jurisdictions, often requiring them to maintain separate inventory records or reconcile their financial statements.

Furthermore, LIFO can lead to unusual results in periods of declining inventory levels, known as "LIFO liquidation." If a company sells more units than it purchases in a period, it must dip into older, lower-cost inventory layers to calculate its cost of goods sold. This can artificially inflate reported net income and taxable income in a given period, negating some of the tax benefits typically associated with LIFO.

LIFO Accounting vs. FIFO Accounting

The primary difference between LIFO accounting and FIFO accounting lies in their assumptions about the flow of inventory costs. LIFO (Last-In, First-Out) assumes that the most recently purchased inventory items are the first ones sold. In contrast, FIFO (First-In, First-Out) assumes that the oldest inventory items are sold first.

This fundamental difference leads to distinct impacts on a company's financial statements, especially during periods of changing prices. During inflation, LIFO typically results in a higher cost of goods sold (COGS) and a lower reported net income and taxable income, offering a tax advantage. Conversely, FIFO would show a lower COGS and higher net income. For the balance sheet, LIFO's ending inventory often reflects older, lower costs, which may not represent current values. FIFO's ending inventory, by expensing older costs first, tends to reflect more current costs. The choice between LIFO and FIFO directly influences a company's reported profitability and its tax liability.

FAQs

Why do companies use LIFO accounting?

Companies primarily use LIFO accounting in the United States to reduce their tax liability during periods of inflation. By assuming that the most expensive, recently purchased goods are sold first, LIFO leads to a higher cost of goods sold (COGS) and, consequently, a lower reported taxable income.

Is LIFO accounting allowed internationally?

No, LIFO accounting is generally not permitted under International Financial Reporting Standards (IFRS), which are used by most countries outside the United States. IFRS aims for financial statements to reflect a more realistic flow of inventory and current values on the balance sheet.

How does LIFO accounting affect a company's net income?

During periods of rising costs, LIFO accounting results in a higher cost of goods sold (COGS) because it assumes the most recently purchased (and typically more expensive) inventory is sold first. A higher COGS directly reduces a company's gross profit and, subsequently, its reported net income.

What is the LIFO conformity rule?

The LIFO conformity rule is a U.S. tax regulation that mandates if a company chooses to use LIFO for income tax purposes, it must also use LIFO for preparing its external financial statements to shareholders and creditors. This rule aims to prevent companies from presenting inflated profits to investors while simultaneously lowering their taxable income.