LIFO Inventory Accounting: Explanation and Usage

A comprehensive overview of Last-In, First-Out (LIFO) Inventory Accounting, its definitions, applications under GAAP, and restrictions under IFRS.

Last-In, First-Out (LIFO) Inventory Accounting is an inventory valuation method used to calculate the cost of goods sold (COGS) and the remaining inventory’s value on the balance sheet. Under the LIFO method, the most recently acquired items (the last in) are assumed to be the first sold (the first out), which directly affects the financial statements.

Definition and Purpose

LIFO is based on the assumption that the latest inventory purchased or produced is the first to be used or sold. This method contrasts with First-In, First-Out (FIFO) and Weighted Average Cost methods. The primary application of LIFO is to match recent costs with current revenues, which may lead to lower taxable income in periods of rising prices.

Accounting Standards: GAAP vs. IFRS

GAAP (Generally Accepted Accounting Principles)

Under GAAP, LIFO is an acceptable inventory valuation method. It allows companies flexibility in choosing an inventory accounting method that best reflects their financial situation and operational environment.

IFRS (International Financial Reporting Standards)

IFRS prohibits the use of LIFO. Companies reporting under IFRS must use alternative methods such as FIFO or Weighted Average Cost, which are considered to provide a more realistic reflection of the inventory and true margins.

Key Formulas in LIFO Accounting

The primary formula used in LIFO accounting to calculate the cost of goods sold is:

$$ \text{COGS} = \text{Cost of most recent inventory} \times \text{Quantity sold} $$

The ending inventory is calculated by subtracting the sold goods from the total inventory and combining the cost of the remaining inventory:

$$ \text{Ending Inventory} = \text{Total Inventory} - \text{COGS} $$

Comparisons with Other Methods

FIFO vs. LIFO

• FIFO (First-In, First-Out): Assumes that the oldest inventory items are sold first. Leads to lower COGS and higher net income during inflation.
• LIFO (Last-In, First-Out): Assumes the newest inventory items are sold first. Leads to higher COGS and lower net income during inflation, providing tax advantages.

Weighted Average Cost

• Weighted Average Cost: Averages out the cost of inventory purchased over a period, providing a middle-ground valuation that can smooth out price fluctuations.

Example

Assume a company has the following inventory purchases:

• January: 100 units at $10 each
• February: 100 units at $12 each
• March: 100 units at $14 each

If the company sells 150 units in April under the LIFO method, the cost of goods sold (COGS) would be calculated as:

$$ \text{COGS} = (100 \text{ units } \times \$14) + (50 \text{ units } \times \$12) = \$1400 + \$600 = \$2000 $$

The ending inventory would then be:

$$ \text{Ending Inventory} = (50 \text{ units } \times \$12) + (100 \text{ units } \times \$10) = \$600 + \$1000 = \$1600 $$

Applications and Considerations

Benefits of LIFO

• Tax Benefits: Higher COGS during periods of inflation can result in lower taxable income, thus deferred tax liability.
• Cost Matching: Better matches current costs with current revenues, providing a more accurate reflection of profit margins.

Drawbacks of LIFO

• Regulatory Restrictions: Prohibited under IFRS, limiting its use for companies operating internationally.
• Inventory Valuation: In times of stable or decreasing prices, LIFO can result in outdated inventory values, potentially misleading stakeholders.

Related Terms

• FIFO (First-In, First-Out): An inventory valuation method assuming the first items in are the first sold, often leading to lower COGS during inflation.
• Weighted Average Cost: An inventory valuation method calculating an average cost per unit of inventory over a specific period, smoothing out price fluctuations.
• Cost of Goods Sold (COGS): The direct costs attributed to the production of goods sold by a company. COGS includes the cost of materials and direct labor.

FAQs

Is LIFO allowed under GAAP?

Yes, LIFO is permissible under GAAP, allowing companies to choose between LIFO, FIFO, or other accounting methods as per their operations.

Can companies using IFRS adopt LIFO?

No, IFRS does not permit the use of LIFO. Companies operating under IFRS need to use FIFO or Weighted Average Cost methods.

Why do companies prefer LIFO during inflation?

LIFO results in higher COGS during inflation, which reduces taxable income and provides significant tax advantages.

References

1. Financial Accounting Standards Board (FASB)
2. International Financial Reporting Standards (IFRS) – Inventory Accounting
3. “Principles of Accounting” by Weygandt, Kieso, and Kimmel

Summary

LIFO inventory accounting is a widely used method under GAAP that assumes the last items added to inventory are the first to be sold. While beneficial for tax purposes in inflationary periods, it is restricted under IFRS, which prefers FIFO and Weighted Average Cost for more realistic financial reporting. Understanding LIFO’s implications on financial statements is crucial for accurate financial analysis and reporting.