LIFO (Last In, First Out)

What is LIFO ?

LIFO (Last-In, First-Out) is an inventory valuation and accounting method used to manage and report inventory costs. Under this method, the most recently acquired inventory (last-in) is the first to be used or sold (first-out), while older inventory remains in stock.

Key Aspects of LIFO

1. Cost Flow Assumption: LIFO assumes that the latest inventory purchases are used up first in production or sales. This does not necessarily reflect the actual physical flow of inventory.

2. Impact on Financial Statements:

   • Cost of Goods Sold (COGS): In times of rising prices, LIFO results in higher COGS because the most recent, more expensive inventory is used first.

   • Net Income: Since COGS is higher under LIFO, net income is lower compared to FIFO (First-In, First-Out).

   • Ending Inventory Value: The inventory remaining on the balance sheet is based on older, lower-cost inventory, which may undervalue the company’s total assets.

3. Tax Benefits: Since LIFO increases COGS, it lowers taxable income, leading to lower tax liabilities. This is a key reason why businesses in inflationary economies prefer LIFO.

4. Inflationary vs. Deflationary Effects:

   • In inflationary periods, LIFO results in lower reported profits and lower taxes.

   • In deflationary periods, LIFO leads to lower COGS, higher profits, and higher taxes.

5. LIFO Reserve: The difference between inventory valuation under LIFO and FIFO. It helps compare financial statements of companies using different inventory methods.

LIFO vs. FIFO

LIFO in Practice

Example

A company purchases inventory as follows:

• 100 units at $10 each

• 100 units at $12 each

If the company sells 100 units under LIFO:

• The latest purchase ($12 per unit) is used first.

• COGS = 100 × $12 = $1,200.

• Remaining inventory = 100 × $10 = $1,000.

Under FIFO:

• COGS = 100 × $10 = $1,000.

• Remaining inventory = 100 × $12 = $1,200.

LIFO Conformity Rule

• In the U.S., companies using LIFO for tax purposes must also use it for financial reporting (GAAP rule).

• International Financial Reporting Standards (IFRS) prohibit LIFO, so companies using IFRS cannot apply LIFO.

Advantages of LIFO

1. Tax Savings: Reduces taxable income in times of inflation.

2. Better Matching Principle: Recent costs match recent revenues.

3. Cash Flow Benefits: Lower taxes mean more cash retained for operations.

Disadvantages of LIFO

1. Lower Reported Profits: Can make a company look less profitable.

2. Inventory Understatement: Older, lower-cost inventory remains on the balance sheet.

3. Complexity: LIFO requires detailed record-keeping and can be harder to manage.

4. Not Allowed Under IFRS: Limits its use globally.

LIFO Liquidation

If a company depletes its inventory without restocking, older (cheaper) inventory gets used, reducing COGS and increasing taxable income, which negates the tax benefits of LIFO.