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What Is Last In, First Out (LIFO) ?

Last in, first out (LIFO) is an inventory costing method where the most recently produced or purchased inventory items are recorded as being sold first. This results in older, lower-cost inventory remaining on the balance sheet. LIFO is used primarily in the US and allows companies to reduce taxable income in periods of rising prices by matching higher costs with revenues. Alternative methods are first in, first out (FIFO) and average costing.

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77 views

What Is Last In, First Out (LIFO) ?

Last in, first out (LIFO) is an inventory costing method where the most recently produced or purchased inventory items are recorded as being sold first. This results in older, lower-cost inventory remaining on the balance sheet. LIFO is used primarily in the US and allows companies to reduce taxable income in periods of rising prices by matching higher costs with revenues. Alternative methods are first in, first out (FIFO) and average costing.

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Niño Rey Lopez
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Last In, First Out (LIFO)

What Is Last In, First Out (LIFO)?


Last in, first out (LIFO) is a method used to account for inventory that records the
most recently produced items as sold first. Under LIFO, the cost of the most
recent products purchased (or produced) are the first to be expensed as cost of
goods sold (COGS), which means the lower cost of older products will be
reported as inventory.

Two alternative methods of inventory-costing include first in, first out (FIFO),


where the oldest inventory items are recorded as sold first, and the average cost
method, which takes the weighted average of all units available for sale during
the accounting period and then uses that average cost to determine COGS and
ending inventory.

KEY TAKEAWAYS

 Last in, first out (LIFO) is a method used to account for inventory.
 Under LIFO, the costs of the most recent products purchased (or
produced) are the first to be expensed.
 LIFO is used only in the United States and governed by the generally
accepted accounting principles (GAAP).
 Other methods to account for inventory include first in, first out (FIFO) and
the average cost method.
 Using LIFO typically lowers net income but is tax advantageous when
prices are rising.
Understanding Last In, First Out (LIFO)
Last in, first out (LIFO) is only used in the United States where all three
inventory-costing methods can be used under generally accepted accounting
principles (GAAP). The International Financial Reporting Standards (IFRS)
forbids the use of the LIFO method.

Companies that use LIFO inventory valuations are typically those with relatively
large inventories, such as retailers or auto dealerships, that can take advantage
of lower taxes (when prices are rising) and higher cash flows.

Many U.S. companies prefer to use FIFO though, because if a firm uses a LIFO
valuation when it files taxes, it must also use LIFO when it reports financial
results to shareholders, which lowers net income and, ultimately, earnings per
share.
Last In, First Out (LIFO), Inflation, and Net Income
When there is zero inflation, all three inventory-costing methods produce the
same result. But if inflation is high, the choice of accounting method can
dramatically affect valuation ratios. FIFO, LIFO, and average cost have a
different impact:

 FIFO provides a better indication of the value of ending inventory (on the


balance sheet), but it also increases net income because inventory that
might be several years old is used to value COGS. Increasing net income
sounds good, but it can increase the taxes that a company must pay.
 LIFO is not a good indicator of ending inventory value because it may
understate the value of inventory. LIFO results in lower net income (and
taxes) because COGS is higher. However, there are fewer inventory write-
downs under LIFO during inflation.
 Average cost produces results that fall somewhere between FIFO and
LIFO.

If prices are decreasing, then the complete opposite of the above is true.

Example of Last In, First Out (LIFO)


Assume company A has 10 widgets. The first five widgets cost $100 each and
arrived two days ago. The last five widgets cost $200 each and arrived one day
ago. Based on the LIFO method of inventory management, the last widgets in
are the first ones to be sold. Seven widgets are sold, but how much can the
accountant record as a cost?

Each widget has the same sales price, so revenue is the same, but the cost of
the widgets is based on the inventory method selected. Based on the LIFO
method, the last inventory in is the first inventory sold. This means the widgets
that cost $200 sold first. The company then sold two more of the $100 widgets. In
total, the cost of the widgets under the LIFO method is $1,200, or five at $200
and two at $100. In contrast, using FIFO, the $100 widgets are sold first, followed
by the $200 widgets. So, the cost of the widgets sold will be recorded as $900, or
five at $100 and two at $200.

This is why in periods of rising prices, LIFO creates higher costs and lowers net
income, which also reduces taxable income. Likewise, in periods of falling prices,
LIFO creates lower costs and increases net income, which also increases
taxable income.

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