Last-In First-Out (LIFO)
An inventory accounting approach in which the most recently manufactured things are recorded as sold first
What Is Last In, First Out (LIFO)?
Last in, first out (LIFO) is an inventory accounting approach in which the most recently purchased or manufactured items, when sold, are recorded as they were 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 products purchased first (unsold) is reported as inventory under it.
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 front rows; 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.
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.
Key Takeaways
- LIFO is an inventory accounting method where the most recently acquired items are considered sold first.
- Often used in the United States, LIFO is common among businesses with extensive inventories, benefiting from lower taxes in rising price scenarios. Contrastingly, international accounting standards (IFRS) prohibit the use of LIFO.
- During inflation, LIFO tends to result in lower net income and higher COGS, potentially impacting valuation ratios.
- LIFO may provide tax advantages by deferring income recognition but results in a lower-quality balance sheet valuation.
Understanding Last In, First Out (LIFO)
Last In, First Out 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, which 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.
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 the average cost are different.
These methods are value inventories differently during inflations.
- LIFO: LIFO causes lower net income and greater COGS during inflation, but it may also result in lower tax obligations. However, LIFO can skew financial statements and may not fairly represent the current market worth of goods.
- FIFO: Due to lower COGS, FIFO usually results in increased net revenue; however, it may also have negative effects on taxes and may not always accurately reflect the market value of the inventory.
- Weighted Average: This method evens out price swings and yields a reliable indicator of inventory value and profitability.
- Although it makes tracking and record-keeping easier, it might not accurately reflect the physical flow of inventory, which could result in reduced net income and greater taxes during inflation.
Making the Decision to Use the LIFO 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.
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.
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 toward 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).
The Poor Valuation Of The Balance Sheet
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 And 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.
Examples of LIFO
While this method might seem counterintuitive to some, it offers distinct advantages, especially in specific economic conditions.
To better understand LIFO in practice, it's beneficial to delve into tangible scenarios where this inventory accounting method is applied.
Example 1
Assume that firm A has ten widgets in total. The first five, each $100, arrived two days ago. The remaining five, each $200, 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
Under LIFO, the calculations would look something like this
| Date | No. Of Units | Price Per Unit |
|---|---|---|
| 12/3 | 5 | $100 |
| 15/3 | 5 | $200 |
| Date | No. Of Units Sold | Price Per Unit | Total |
|---|---|---|---|
| 15/3 | 5 | $200 | $1,000 |
| 12/3 | 2 | $100 | $200 |
| Total | $1,200 | ||
This suggests that the five $200 widgets were the first to sell. The company went on to sell two more $100 widgets.
The total cost of the widgets under the approach is $1,200, divided into five $200 units and two $100 units.
| Date | No. Of Units Sold | Price Per Unit | Total |
|---|---|---|---|
| 12/3 | 5 | $100 | $500 |
| 15/3 | 2 | $200 | $400 |
| Total | $900 | ||
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.
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 equals $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.
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 equals $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
Sharma Corporation opted for the LIFO approach for June. The table below depicts the company's various purchasing transactions for Elite Roasters products. The inventory beginning balance is reflected in the quantity purchased on June 1.
| Date Purchased | Quantity Purchased | Cost per Unit | Units Sold | Cost of Layer #1 | Cost of Layer #2 | Total Cost |
|---|---|---|---|---|---|---|
| June 1 | 150 | $210 | 95 | (55 x $210) | $11,550 | |
| June 7 | 100 | 235 | 110 | (45 x $210) | 9,450 | |
| June 11 | 200 | 250 | 180 | (45 x $210) | (20 x $250) | 14,450 |
| June 17 | 125 | 240 | 125 | (45 x $210) | (20 x $250) | 14,450 |
| June 25 | 80 | 260 | 120 | (25 x $210) | 5,250 |
Sharma Corporation opts for this approach for June. The table above depicts the company's various purchasing transactions for Elite Roasters products. The inventory beginning balance is reflected in the 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, and 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 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.
- There was no change in the inventory layers on June 17 since Sharma purchased 125 extra units on that day 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.
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 this number, 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, totaling $7,701.
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 two main techniques used in accounting to determine the value of inventory are LIFO (Last-In, First-Out) and FIFO (First-In, First-Out).
| Aspect | LIFO | FIFO |
|---|---|---|
| Meaning | 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 first-in, first-out (FIFO) technique posits that the oldest inventories are sold or used in production. |
| Regulations | GAAP permits the Last in, first out approach, while IFRS forbids it. | The FIFO technique is a widely used accounting approach that both GAAP and IFRS have approved. |
| Impact On Inventory | Because old items are kept in the inventory unsold, it can result in them being ruined or lost. The Last in, first out approach might result in inventory losses. | 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. |
| Impact On COGS | A business reports lower COGS and thus lower net income under LIFO when compared to FIFO | A business reports a higher COGS and thus higher net income under FIFO when compared to LIFO |
| Impact During Inflation | In comparison to FIFO, LIFO results in higher COGS and net income during a period of declining inventory costs. | In comparison to LIFO, FIFO results in lower COGS and net income during a period of declining inventory costs. |
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 equals $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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