LIFO (Last In, First Out) is an inventory valuation method in accounting under which the latest items added to inventory are the first ones to be used or sold. This method contrasts with FIFO (First In, First Out), where the oldest items are sold first, and other inventory costing methods such as weighted average cost and specific identification.
Mechanics of LIFO
LIFO assumes that the most recent inventory costs are the first to be assigned to the cost of goods sold (COGS). This has the effect of matching the most recent costs with current revenues, which can provide a closer approximation of current profitability under certain circumstances, especially during periods of inflation.
For example, let’s consider a company that has the following inventory purchases:
- 100 units at $10 each
- 100 units at $12 each
- 100 units at $14 each
If the company sells 150 units, under LIFO, the cost calculation will be as follows:
- 100 units at $14 = $1,400
- 50 units at $12 = $600
Thus, the total COGS under LIFO would be $2,000.
Advantages and Disadvantages
Advantages
- Tax Benefits: During periods of rising prices, LIFO assigns higher costs to goods sold, reducing taxable income.
- Matching Current Costs to Current Revenues: Better reflects current cost levels since the latest inventory costs are used.
Disadvantages
- Inventory Valuation: Older inventory costs may not reflect current market values, leading to understated inventory balances.
- Complexity and Regulation: LIFO can be more complex to maintain and is not permitted under International Financial Reporting Standards (IFRS).
- Potential for Income Manipulation: Companies can manipulate net income by timing purchases when using LIFO.
Historical Context
LIFO became increasingly popular in the mid-20th century as companies looked for ways to manage rising prices post-World War II. Particularly in the United States, LIFO was adopted partly due to its tax deferral advantages during inflationary periods. However, LIFO is not permitted under IFRS, creating a significant divergence in inventory practices between companies that report under US GAAP (Generally Accepted Accounting Principles) and those reporting under IFRS.
Applicability and Considerations
LIFO is especially beneficial in inflationary environments but may not be suitable for all types of businesses. Industries with fluctuating prices, like raw materials, often utilize LIFO. However, it can be problematic for companies looking to present higher net earnings, as COGS under LIFO is higher during inflation.
Related Terms
- FIFO (First In, First Out): An inventory valuation method where the oldest inventory items are recorded as sold first.
- Weighted Average Cost: An inventory method that calculates the cost of ending inventory and COGS based on the average cost of all items available for sale during the period.
- Specific Identification: An inventory method where the actual cost of each specific item is known and used in accounting records.
FAQs
Is LIFO allowed under IFRS?
Can LIFO result in lower taxes?
How does LIFO affect financial statements?
Summary
LIFO is a widely-used inventory valuation method under US GAAP that aligns recent costs with current revenues, beneficial during inflation but potentially complex to implement and not allowed under IFRS. Understanding its impact on financial statements and tax is crucial for effective financial management.
References
- Financial Accounting Standards Board (FASB), Accounting Standards Codification (ASC) 330-10, “Inventory”.
- International Accounting Standards Board (IASB), IAS 2, “Inventories”.
- “Introduction to Management Accounting” by Charles T. Horngren and Gary L. Sundem.
Understanding and applying LIFO correctly can significantly influence financial outcomes, making it a critical concept in accounting and finance.
