Last in first out (L.I.F.O.)

Last in first out (LIFO) is an inventory valuation method where the most recently acquired items are sold or used first, leaving older inventory items remaining in stock.
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Updated on Jun 21, 2024
Reading time 4 minutes

3 key takeaways

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  • LIFO assumes that the most recently purchased or produced items are sold or used first.
  • This method can reduce taxable income during periods of inflation by matching current costs with current revenues.
  • LIFO is not permitted under International Financial Reporting Standards (IFRS), but it is allowed under Generally Accepted Accounting Principles (GAAP) in the United States.

What is last in first out (LIFO)?

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Last in first out (LIFO) is an accounting method used to manage inventory and calculate the cost of goods sold (COGS). Under LIFO, the most recently acquired or produced items are assumed to be sold or used first, which means the cost of the latest inventory is assigned to COGS, while older inventory costs remain on the balance sheet.

This method contrasts with first in first out (FIFO), where the oldest inventory items are recorded as sold first. LIFO can affect financial statements and tax calculations, especially in times of price inflation.

How LIFO works

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Example

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Consider a company with the following inventory purchases:

  • 100 units at $10 each
  • 200 units at $12 each
  • 150 units at $15 each

If the company sells 250 units, LIFO accounting assumes that the 150 units purchased at $15 each and 100 of the units purchased at $12 each are sold first. The cost of goods sold would be calculated as follows:

  • 150 units x $15 = $2,250
  • 100 units x $12 = $1,200
  • Total COGS = $3,450

The remaining inventory would include:

  • 100 units at $10 each
  • 100 units at $12 each

Financial implications

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Using LIFO during periods of inflation (when prices are rising) results in higher COGS because the latest, more expensive inventory is used up first. This leads to lower reported net income and, consequently, lower taxable income. However, it also means that the inventory remaining on the balance sheet is valued at older, lower costs, which can understate the company’s inventory value.

Advantages of LIFO

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Tax benefits

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By matching higher current costs with current revenues, LIFO can reduce taxable income during periods of rising prices. This can provide significant tax savings for companies.

Better matching of costs and revenues

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LIFO more accurately matches current costs with current revenues, which can provide a clearer picture of profitability in environments with fluctuating prices.

Disadvantages of LIFO

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Inventory undervaluation

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LIFO can result in inventory being valued at outdated, lower costs on the balance sheet, potentially misrepresenting the true value of the inventory.

Compliance limitations

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LIFO is not allowed under International Financial Reporting Standards (IFRS), which limits its use to companies reporting under U.S. Generally Accepted Accounting Principles (GAAP). This can be a drawback for multinational companies that need to reconcile financial statements across different accounting standards.

Complexity

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LIFO can be more complex to maintain, requiring detailed tracking of inventory layers and frequent updates to cost records, especially in companies with large or diverse inventories.

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  • First in first out (FIFO): Learn about the FIFO inventory valuation method, which assumes that the oldest inventory items are sold first.
  • Inventory management: Explore various strategies and methods for managing inventory effectively.
  • Cost of goods sold (COGS): Understand how COGS is calculated and its impact on financial statements and taxation.

Last in first out (LIFO) is a valuable inventory valuation method for companies seeking to manage tax liabilities and better match current costs with revenues. However, its limitations and complexity must be carefully considered when choosing an inventory accounting method.


Sources & references

Arti

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