Last-In First-Out (LIFO)

An inventory accounting approach in which the most recently manufactured things are recorded as sold first.

Last in, first out is an inventory accounting approach in which the most recently manufactured things are recorded as sold first. 

The cost of the most recent products acquired (or manufactured) is expensed first as the cost of goods sold (COGS), which means the lower cost of earlier products is reported as inventory under it.

Other alternative methods of inventory costing are first-in, first-out(FIFO), and the average cost method. The former records the oldest inventory as sold first, and the latter accounts for the weighted average of all units available for sale during the accounting period

It is an inventory valuation method based on the idea that assets generated or bought last are expensed first. In other words, the newest purchased or manufactured commodities are eliminated and expensed first under the last-in, first-out technique. 

As a result, old inventory expenses are left on the balance sheet while new inventory costs are expensed first.

Consider a retail shelf where a clerk adds products from the front and consumers take their selections from the show; the remaining inventory items further back on the shelf are rarely accepted and thus remain on the shelf - this is a LIFO scenario.

The scenario has the disadvantage of being uncommon in practice. For example, if a corporation followed the LIFO process flow, a large portion of its inventory would be very old and likely obsolete. 

However, a corporation must not be familiar with the process flow to employ the method.

Last In, First Out is a concept that you should be aware of 

It is only utilized in the United States, where all three inventory-costing systems are permissible under generally accepted accounting standards (GAAP). The approach is prohibited under the International Financial Reporting Standards (IFRS).

Companies that employ this inventory valuation often have extensive inventories, such as retailers or auto dealerships, who can benefit from lower taxes (when prices are rising) and higher cash flows by using last in, first out inventory valuations.

However, many US corporations favor FIFO because if a company uses a LIFO value when filing taxes, it must also use its valuation when reporting financial results to shareholders, lowering net income and, ultimately, earnings per share.

Inflation, Last In, First Out, and Net Income

When there is no inflation, the results of all three inventory-costing methodologies are the same. 

However, if inflation is substantial, the accounting system chosen might significantly impact valuation ratios. This is because the effects of both methods and average cost are different.

Because inventory that may be several years old is utilized to value COGS, FIFO provides a better estimate of the value of ending inventory (on the balance sheet) and boosts net profitability. 

While increasing net income sounds nice, it can also increase a company's tax burden.

Because LIFO may understate inventory value, it is not a strong indicator of ending inventory value. Because COGS is higher, it results in lesser net income and taxes. Inflation, however, results in fewer inventory write-downs.

  • The results of average cost are midway between FIFO and LIFO. If prices are falling, the exact opposite of the above is true.
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Making the Decision to Use the Method

The default method for inventory costing is FIFO; if you want to use LIFO, you must choose it. Also, after you've switched to it, you won't be able to revert to FIFO unless the IRS permits you. 

If you want to switch to LIFO, you'll need to fill out and submit Form 970. and include it with your tax return for the year you started using it.

You'll need to do the following to finish the election application:

  • But, first, indicate which goods will be subject to its mechanism.
  • Identify and describe the inventory method(s) you used to value these commodities the previous year, and
  • Describe the commodities for which the Last In First Out approach will not be employed.

You must also offer thorough information about the costing method or approaches you will use (specific goods, dollar value, or another approved method).

Last-in, first-out will result in a higher cost of goods sold and a lower closing inventory in regular periods of rising prices. As a result, COGS will be lower, and closing inventory will be greater under FIFO.

What Is LIFO Inventory Costing, and How Does It Work?

You have numerous choices for determining the cost of your inventory when doing the COGS calculation. 

The following are the three most frequent methods for valuing inventory:

  • Specific Identification: This is used for inventory kinds when the actual cost may be identified and matched to the goods (for example, a car using the Vehicle ID Number)
  • LIFO: This strategy assumes that the LAST objects purchased or created are the first items sold, consumed, or disposed of.
  • The First In, First Out (FIFO): technique assumes that the first products you buy or create are the first items you sell, consume, or dispose of as a business owner.

If you choose this cost technique, you can use one of the IRS - approved criteria to group goods to make counting them easier. The following are two rules for valuing it:

  • In the dollar-value technique, items and products are classified based on their characteristics.
  • The simplified dollar-value technique uses several inventory classes in general categories.

The Financial Statements and the LIFO Inventory Valuation Method

Consider the example of Last-In-First-Out versus FIFO, another inventory valuation method. Inventory and COGS are different for the two techniques. Now it's time to consider the consequences of using LIFO on a company's financial statements.

The valuation of the balance sheet is of poor quality.

The balance sheet reveals worse quality inventory information when it is used. This is because it first depreciates the most recent purchases, leaving earlier obsolete costs as inventory on the balance sheet.

Consider a corporation with two snowmobiles in its initial inventory, each costing $50,000. A new snowmobile is purchased for $75,000 by the corporation. The corporation will deduct the cost of the newer snowmobile ($75,000) from selling one snowmobile.

As a result, compared to other inventory valuation methods, it will produce lower-quality information on the balance sheet because the older snowmobile cost is outdated compared to current snowmobile costs.

Matching income statements of high quality

Because its expenses are the most recent costs, the income statement is more aligned. The revenue from inventory sales is compared to the cost of the most current inventory.

Consider a corporation with a starting inventory of 100 calculators at a $5 per unit cost. Due to the lack of resources to produce the calculators, the corporation ordered another 100 devices at a higher unit cost of $10 each.

Under this system, if the corporation sold 50 calculators, the most recent calculator costs would be matched with the revenue produced from the sale.

On the income statement, it would provide significant revenue and cost of goods sold matching.

LIFO Inventory Accounting's Consequences

Companies employ it because they assume that inventory costs will rise over time, which is a logical premise in times of increasing pricing. 

If you utilize this in this circumstance, the most recently acquired inventory will always be higher than the cost of earlier acquisitions. Therefore the ending inventory balance will be valued at earlier costs, while the cost of products sold would be valued at the most recent costs.

 A corporation can reduce its stated level of profitability and hence defer the recognition of income taxes by transferring high-priced inventory towards the cost of goods sold. 

Because, in most cases, income tax deferral is the only reason for LIFO, it is prohibited by international financial reporting standards (though it is still allowed in the United States under the approval of the Internal Revenue Service).

Accounting Standards 

The last-in, first-out approach is forbidden under IFRS and ASPE. The use of Last-In-First-Out is, however, approved by GAAP

Due to potential distortions in a company's profitability and financial statements, the inventory valuation approach is disallowed under IFRS and ASPE.

The 2003 amendment of IAS Inventories made it illegal to use LIFO to compile and present financial statements. One of the reasons is that in the event of price inflation, it might lessen the tax burden. 

Assume the sales price of a unit of inventory is $15, as in Example 2:

COGS = $1,700 

Revenue = 350 x $15 = $5,250 

Under LIFO, 

Gross earnings are $5,520 – $1,700 = $3,820.

COGS = $875 under FIFO.

350 x $15 = $5,250 in revenue 

Under FIFO, 

Gross earnings are $5,520 – $875 = $4,645

Even though the sales price remained the same, the corporation claimed a decreased gross profit under LIFO. It may appear illogical that a business would underreport profits. 

However, when it is used, the cost of goods sold is recorded at a greater level, resulting in a lesser profit and, as a result, a lower tax. As a result, it can be used to reduce tax liabilities.

Using outdated information on the balance sheet is the primary rationale for abandoning this approach under IFRS and ASPE. Remember that the Last In First Out approach has a low balance sheet valuation quality. 
As a result, the balance sheet may contain obsolete costs irrelevant to financial statement users.

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Example

Example 1

Assume that firm A has a total of ten widgets. The first five widgets, each costing $100, came two days ago. The remaining five widgets cost $200 each and were delivered only the other day. 

According to the Last in, first out technique of inventory management, the last widgets are the first to be sold. So seven widgets are sold, but how much of a cost can the accountant record?

Solution

The income is the same because each widget has the same sales price, but the cost of the widgets is determined by the inventory method chosen. Therefore, the last inventory sold is the first inventory sold according to the approach. 

This suggests that the five $200 widgets were the first to sell. The company went on to sell two more $100 widgets.

Widgets

The total cost of the widgets under the approach is $1,200, divided into five $200 units and two $100 units. On the other hand, FIFO sells the $100 widgets first, followed by the $200 widgets. 

As a result, the cost of the widgets sold will be $900, or five for $100 and two for $200. Rising prices generate higher fees and decrease net revenue, lowering taxable income. 

Similarly, when prices fall, the approach reduces costs and increases net income, improving taxable income.

Example 2

Company A reported an initial inventory of 200 units at $2 per unit. In addition, the corporation purchased. 

  • 125 units for $3 each unit.
  • 170 items at $4 each
  • 300 items at $5 each

What would be the sequence of cost expenses if the company sold 350 units in LIFO and FIFO?

Solution

Under LIFO: 

As shown above, 300 units at $5 per unit equal $1,500 in COGS. 

The cost of goods sold (COGS) starts with the most recently purchased inventory and works its way up to the most recently purchased inventory until the required number of units sold is met.

Units

For the sale of 350 units, the following information is required: 

COGS for 50 units at $4 per unit is $200.

For a sale of 350 units, the total cost of goods would be $1,700.

The remaining unsold 450 would be recorded as inventory on the balance sheet, costing $1,275. 

At $4 per unit, 125 units equal $500 in inventory.

In stock: 125 units at $3 each = $375.

For $2 per unit, 200 units equal $400 in inventory. 

Under FIFO:

The  350 units sold as

200 @ $2 = $400

125 @ $3 = $375

25 @ $4 = $100 

The total cost will be $875, and the remaining inventory cost is 150 @ $4 and 300 @ $5, i.e., 2100. 

Example 3

For June, Sharma Corporation opts for the LIFO approach. The table below depicts the company's Elite Roasters product's various purchasing transactions. The inventory beginning balance is reflected in quantity purchased on June 1.

Company's Elite Roasters product's various purchasing transactions
Date PurchasedQuantity PurchasedCost per UnitUnits SoldCost of Layer #1Cost of Layer #2Total Cost
June 1150$21095(55 x $210) $11,550
June 7100235110(45 x $210) 9,450
June 11200250180(45 x $210)(20 x $250)14,450
June 17125240125(45 x $210)(20 x $250)14,450
June 2580260120(25 x $210) 5,250

For June, Sharma Corporation opts for the approach. The table above depicts the company's Elite Roasters product's various purchasing transactions. The inventory beginning balance is reflected in quantity purchased on June 1.

Solution 

The transactions listed in the previous table are described in the bullet points below:

  • On June 1, Sharma started with a 150-unit inventory balance and sold 95 of them between June 1 and June 7. One inventory tier of 55 units at $210 apiece remains.
  • On June 7, Sharma purchased 100 more units and sold 110 between June 7 and 11. 

We presume that the most recent purchase was sold first under last in, first out. Thus there is just one inventory layer left, which has now been decreased to 45 units.

  • On June 11, Sharma purchased 200 more units on June 11 and sold 180 units between June 11 and June 17, resulting in a new inventory tier of 20 units for $250. As a result, the "Cost of Layer #2" column in the table now includes this new layer.
  • On June 17, there was no change in the inventory layers since Sharma purchased 125 extra units on June 17 and sold 125 units between June 17 and June 25.
  • On June 25, Sharma purchased an additional 80 units and sold 120 units between June 25 and the end of the month. During this time, sales outnumber purchases. Therefore, the second inventory layer and a portion of the first are deleted. 

Sales

The end outcome is a $5,250 ending inventory balance, calculated by multiplying 25 units of ending inventory by the $210 cost in the first tier at the beginning of the month.

Example 4

Assume a product is produced in three batches over a year. The following are the costs and quantities of each set (in a sequence of production):

  • Batch 1: 4,000 pieces produced for $8,000
  • Batch 2: 1,500 pieces produced for $7,000
  • Batch 3: 1,700 pieces produced for $7,700

Solution 

The total number of pieces produced was 7,200. The total price was $22,700. The average price of a single piece is $3.15.

Then, for each batch generated, determine the unit costs.

  • Batch 1: $8,000 divided by 4,000 equals $2.
  • $7,000/1,500 = $4.67 in batch 2
  • Batch 3: $7,700 divided by 1,700 is $4.53

Under Last in first out accounting, you start with the premise that you have sold the most recent (last items) and move backward to establish the cost of units sold.

Let's imagine you sold 4,000 units in a year. If you use it, you'll think that the items in Batch 3 were sold first. As a result, the first 1,700 units sold from the previous batch cost $4.53 each. That adds up to $7,701 in total.

Chain

The following 1,500 pieces from Batch 2 sold for $4.67 each, totaling $7,005.

And the final 800 pieces from Batch 1 sold for $2 each, totaling $800.

The remaining 1200 units from the initial batch will cost $2 each, totaling $2,400. These classes will begin next year. FIFO assumes that the first batch of items will be sold first. Assuming that 4,000 units were sold in the case above:

  • Each of the 2,000 Batch 1 pieces is valued at $2.00, for a total of $4,000.
  • Then 1,500 items from Batch 2 are counted and valued at $4.67 each, for a total of $7,000.
  • Finally, 500 items from Batch 3 are counted and valued at $4.53 apiece, for a total of $2,265.

Under FIFO, the total cost is $13,265.

Under Last In First Out, the total inventory cost was $15,506.

The cost of the remaining products is $5,436 under FIFO and $2,400 under LIFO.

LIFO vs. FIFO

The following are the distinctions:

  • The first-in, first-out (FIFO) technique posits that the oldest inventories are sold or used in production.
  • The Last in, first, out technique, presupposes that the most recent purchases or fresh inventories arrive and are sold or utilized in production first.
  • The FIFO technique is a widely used accounting approach that both GAAP and IFRS have approved.
  • GAAP permits the Last in, first out approach, while IFRS forbids it.
  • The FIFO technique is a rational strategy to reduce inventory losses due to obsolescence – expired or stale products for production or sale - by following the natural inventory flow.
  • Because of old-fashioned or ruined items, the Last in, first out approach might result in inventory losses.

To clarify, LIFO prioritizes the use of the most recent inventories. We'll compare it to FIFO in the following example (first in, first out). The oldest costs are paid first under a FIFO system.

Consider the identical scenario as before. Remember that the cost flows for the sale of 350 units under Last in first out are as follows:

In contrast, the FIFO technique of inventory valuation, which costs the oldest inventories first, is as follows:

The selling of 350 apartments under FIFO:

For $2 per unit, 200 units equal $400 in COGS.

COGS = $375 for 125 units @ $3 each.

For $4 per unit, 25 units equal $100 in COGS.

The company would report $875 in cost of goods sold and $2,100 in inventory.

COGS = $1,700, $1,275 in inventory under LIFO.

COGS = $875 Inventory = $2,100 under FIFO

As a result, the COGS and inventory financial statements depend on the inventory valuation technique applied. 

There are additional costs incurred when Last-In-First-Out is used. As detailed below, it has various ramifications for a company's financial accounts.

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Researched and authored by Deeksha Pachauri / LinkedIn

Reviewed and Edited by Savan Sabu | LinkedIn

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