Lifo last in first out: Meaning, Criticisms & Real-World Uses

What Is LIFO Last In, First Out?

LIFO, or Last In, First Out, is an inventory valuation method used in cost accounting that assumes the most recently purchased or produced goods are the first ones sold. This approach directly impacts a company's reported Cost of Goods Sold (COGS) and, consequently, its Net Income and Tax Liability. Under LIFO, the costs of the latest inventory acquisitions are matched against current revenue, reflecting a more current cost of sales, particularly during periods of changing prices.

History and Origin

The LIFO method of inventory accounting emerged in the United States during the 1930s, a period marked by significant economic volatility and inflation. It was developed as a response to the challenges businesses faced in accurately reflecting the cost of their inventory amidst fluctuating prices²⁴. Historically, LIFO can be seen as an evolution of the "base stock method," which aimed to treat a certain minimum quantity of inventory as a permanent investment²³.

LIFO gained legal recognition in the U.S. tax code in 1939, allowing companies to use LIFO for tax purposes if they also used it for financial reporting²². The Internal Revenue Service (IRS) played a significant role in its acceptance and interpretation, particularly through the introduction of the LIFO conformity rule²⁰, ²¹. Early proponents included petroleum refiners and metals companies, with the American Petroleum Institute recommending its use as early as 1934¹⁹. Over time, tax laws were liberalized to encourage its use, and LIFO usage among large public companies saw a marked increase from 1972 to 1986, coinciding with periods of high inflation and interest rates¹⁷, ¹⁸. The history of LIFO illustrates the complex interplay between accounting theory, tax regulations, and economic conditions¹⁶.

Key Takeaways

LIFO (Last In, First Out) is an inventory costing method where the most recent inventory costs are expensed first.
In periods of rising prices, LIFO generally results in a higher Cost of Goods Sold and a lower reported Net Income, leading to lower Taxable Income.
The LIFO conformity rule in the U.S. requires companies to use LIFO for financial reporting if they use it for tax purposes.
LIFO is permitted under U.S. GAAP but is prohibited under IFRS.
This method can present a more conservative picture of profitability during inflationary times but may undervalue remaining inventory on the Balance Sheet.

Formula and Calculation

The LIFO method does not rely on a single, universal formula like some financial ratios. Instead, it is a cost flow assumption applied when calculating the Cost of Goods Sold and the value of ending inventory.

To calculate COGS and ending inventory under LIFO, you need to track the cost of each batch of inventory purchased. When a sale occurs, the cost assigned to the goods sold is taken from the most recent purchases. The remaining inventory is then valued using the costs of the oldest purchases.

Consider a simplified approach for calculating COGS:

\text{COGS}_{\text{LIFO}} = \sum (\text{Units Sold from Most Recent Purchase} \times \text{Cost of Most Recent Purchase})

And for ending inventory:

\text{Ending Inventory}_{\text{LIFO}} = \sum (\text{Units Remaining from Oldest Purchase} \times \text{Cost of Oldest Purchase})

Where:

Units Sold from Most Recent Purchase: The quantity of units sold that are assumed to be from the latest inventory acquisition.
Cost of Most Recent Purchase: The unit cost of the latest inventory acquisition.
Units Remaining from Oldest Purchase: The quantity of units still in stock that are assumed to be from the earliest inventory acquisitions.
Cost of Oldest Purchase: The unit cost of the earliest inventory acquisitions.

This method contrasts with other inventory valuation methods like Weighted-Average Cost, which averages all costs.

Interpreting the LIFO

Interpreting financial statements prepared using LIFO requires an understanding of its underlying assumption and its impact on reported figures. Because LIFO assumes the last units purchased are the first ones sold, it typically results in a higher Cost of Goods Sold during periods of rising prices. This higher COGS leads to a lower reported Gross Profit and, consequently, a lower net income on the Income Statement.

For analysts and investors, a lower reported net income due to LIFO can make a company appear less profitable than it might otherwise seem under alternative methods. However, this lower profit also translates to lower taxable income, which can result in tax savings for the company. It's crucial to consider the "LIFO reserve," which is the difference between inventory valued under FIFO and LIFO. This reserve can help financial statement users adjust reported figures to compare companies using different inventory methods. A significant LIFO reserve on the balance sheet can indicate that the reported inventory value is substantially lower than its current replacement cost¹⁵.

Hypothetical Example

Let's consider a small electronics retailer, "TechGadget," that sells a popular smart home device.

Purchases:

January 5: 100 units at $50 each
March 10: 150 units at $55 each
May 20: 80 units at $60 each

Sales:

June 15: TechGadget sells 200 units of the smart home device.

To calculate the Cost of Goods Sold (COGS) using the LIFO method:

Identify the most recent purchases: The latest purchase was 80 units at $60 each (May 20). These are expensed first.
- 80 units * $60 = $4,800
Move to the next most recent purchase: TechGadget still needs to account for 120 more units (200 total sold - 80 from May 20). The next most recent purchase was 150 units at $55 each (March 10).
- 120 units * $55 = $6,600

LIFO Cost of Goods Sold (COGS): $4,800 + $6,600 = $11,400

Ending Inventory Calculation:

After selling 200 units, the remaining inventory consists of:

From March 10 purchase: 150 units - 120 units sold = 30 units at $55 each = $1,650
From January 5 purchase: 100 units at $50 each = $5,000

LIFO Ending Inventory: $1,650 + $5,000 = $6,650

In this example, the LIFO method assumes that the most expensive units (from recent purchases) were sold, resulting in a higher COGS and a lower reported gross profit compared to other methods like FIFO. This also leaves the older, lower-cost inventory on the balance sheet.

Practical Applications

LIFO is primarily applied in industries where inventory costs tend to rise over time or where there is a rapid turnover of physical goods, such as retail, manufacturing, and petroleum industries. Its primary real-world application stems from its potential tax advantages in inflationary environments.

In the United States, companies can opt to use LIFO for their internal accounting and financial reporting. If adopted for tax purposes, companies are required by the LIFO conformity rule to also use it for their primary financial statements presented to shareholders and creditors¹⁴. This rule prevents businesses from using LIFO to lower taxable income while simultaneously presenting higher profits to investors using a different method¹³.

For businesses operating in an environment of rising costs, LIFO results in a higher Cost of Goods Sold, which leads to a lower reported net income and, consequently, a reduced tax liability¹². This tax deferral can be a significant benefit, as it allows a company to retain more cash that would otherwise be paid in taxes. However, companies must maintain meticulous accounting records to verify their LIFO computations and comply with IRS regulations¹¹.

Limitations and Criticisms

While LIFO offers potential tax benefits, it also presents several limitations and has faced significant criticism, particularly regarding its impact on financial reporting and comparability. One major criticism is that LIFO often does not reflect the actual physical flow of goods for most businesses, where older inventory is typically sold before newer inventory¹⁰. This can lead to a disconnect between the accounting assumption and operational reality.

A key drawback of LIFO, especially in inflationary periods, is that it results in older, lower costs remaining on the balance sheet for inventory. This can significantly undervalue a company's inventory in its financial statements, making the balance sheet appear less robust than it might be. Critics argue this distorts the true financial position of the company⁸, ⁹.

Furthermore, LIFO can lead to "LIFO liquidation" if a company's inventory levels decline. When current purchases are less than sales, older, lower-cost inventory layers are "liquidated" and included in COGS, which can artificially inflate reported net income, leading to unexpected swings in profitability that do not reflect ongoing operational performance⁷.

Perhaps the most significant limitation globally is that LIFO is prohibited under International Financial Reporting Standards (IFRS), which are used by most countries worldwide⁶. This lack of global acceptance creates challenges for multinational corporations and makes it difficult for investors to compare the financial performance of U.S. companies using LIFO with companies in other countries that adhere to IFRS⁵. The declining use of LIFO reflects changes in global accounting standards and underlying economic trends, as its tax advantages diminished with lower inflation and tax rates in later decades⁴.

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

LIFO (Last In, First Out) and FIFO (First In, First Out) are two fundamental accounting principles for valuing inventory and determining the Cost of Goods Sold (COGS). The core difference lies in their assumptions about which inventory units are sold first.

Feature	LIFO (Last In, First Out)	FIFO (First In, First Out)
Inventory Flow Assumption	Assumes the most recently purchased goods are sold first.	Assumes the oldest purchased goods are sold first.
COGS in Rising Prices	Higher COGS, as newer, typically more expensive, units are expensed.	Lower COGS, as older, typically cheaper, units are expensed.
Net Income in Rising Prices	Lower net income, leading to lower taxable income and tax liability.	Higher net income, leading to higher taxable income and tax liability.
Ending Inventory Value	Lower value on the balance sheet, reflecting older, lower costs.	Higher value on the balance sheet, reflecting newer, higher costs.
Global Acceptance	Primarily accepted under U.S. GAAP only.	Widely accepted under both U.S. GAAP and IFRS.

The confusion between LIFO and FIFO First In, First Out often arises because they both deal with inventory costing but produce different financial outcomes, especially during periods of inflation or deflation. Companies choose between them based on factors like tax implications, industry practice, and the desire to match specific costs with revenues.

FAQs

Why do companies use LIFO?

Companies primarily use LIFO for its tax benefits, especially in an inflationary environment. By expensing the most recently acquired (and often most expensive) inventory costs first, LIFO results in a higher Cost of Goods Sold and a lower reported Net Income. This leads to a lower taxable income, which can reduce a company's tax liability and conserve cash.

What is the LIFO conformity rule?

The LIFO conformity rule is a U.S. tax regulation that mandates if a company uses the LIFO method for tax purposes, it must also use LIFO for its external financial reporting to shareholders and creditors. This rule, enforced by the IRS, aims to prevent companies from presenting a higher profit to investors while reporting a lower profit for tax purposes², ³.

Is LIFO allowed under IFRS?

No, LIFO is not permitted under International Financial Reporting Standards (IFRS). IFRS requires companies to use methods that reflect the actual flow of inventory, such as FIFO or the weighted-average cost method, because LIFO is generally considered to not accurately represent the physical movement of goods or the true economic value of inventory¹.

How does LIFO impact a company's balance sheet?

Under LIFO, the inventory remaining on the balance sheet is valued at the oldest costs. In an inflationary environment, this means the reported value of inventory on the balance sheet can be significantly lower than its current replacement cost or market value. This can make a company's assets appear less valuable than they actually are, potentially impacting financial ratios and investor perception.