last-in, first-out (LIFO)
LIFO is the acronym for last-in, first-out. It is a cost flow assumption that can be used by U.S. companies in moving the costs of products from inventory to the cost of goods sold.
Under LIFO the latest or more recent costs of products purchased (or produced) are the first costs expensed as the cost of goods sold. This means that the costs of the oldest products will be reported as inventory.
It is important to understand that while LIFO is matching the latest or most recent costs with sales on the income statement, the company can be shipping the oldest physical units of product. In other words, the flow of costs does not have to match the flow of the physical units. This is why LIFO is a cost flow assumption or an assumed flow of costs. (If the costs flowing matched the physical units flowing, it would be the specific identification method and there would be no need to assume a cost flow.)
Let’s illustrate LIFO with a company that has three units of the same product in inventory. The units were purchased at different costs and in the following sequence: $40, $44, and $46. The company ships the oldest item (the one purchased for $40). However, under LIFO the company will report its cost of goods sold as $46 (the latest cost). Note that the last cost of $46 is the first cost out of inventory—the LIFO assumption. This means that the company’s inventory will report the two first or oldest costs of $40 and $44.
LIFO has become popular because of inflation and the fact that the income tax rules permit companies to use LIFO. With LIFO a company is able to match its recent, more-inflated costs with its sales thereby reporting less taxable income than would occur under another cost flow assumption. Also, the matching of the latest costs with recent sales is a better indicator of the company’s current profitability.
Example of Last-In, First-Out (LIFO)
Company A reported beginning inventories of 200 units at $2/unit. In addition, the company made purchases of:
- 125 units @ $3/unit
- 170 units @ $4/unit
- 300 units @ $5/unit
If the company sold 350 units, the order of cost expenses would be as follows:
300 units at $5/unit = $1,500 in COGS, as illustrated above. The cost of goods sold (COGS) is determined with the last purchased inventories and moves it upwards to beginning inventories until the required number of units sold is fulfilled. For the sale of 350 units:
- 50 units at $4/unit = $200 in COGS
The total cost of goods sold for the sale of 350 units would be $1,700.
The remaining unsold 450 would remain on the balance sheet as inventory at a cost of $1,275.
- 125 units at $4/unit = $500 in inventory
- 125 units at $3/unit = $375 in inventory
- 200 units at $2/unit = $400 in inventory
LIFO vs. FIFO
To reiterate, LIFO expenses the newest inventories first. In the following example, we will compare it to FIFO (first in first out). FIFO expenses the oldest costs first.
Consider the same example above. Recall that under LIFO, the cost flows for the sale of 350 units are as follows:Compare it to the FIFO method of inventory valuation, which expenses the oldest inventories first.
Compare it to the FIFO method of inventory valuation, which expenses the oldest inventories first:
Under FIFO, the sale of 350 units:
- 200 units at $2/unit = $400 in COGS
- 125 units at $3/unit = $375 in COGS
- 25 units at $4/unit = $100 in COGS
The company would report the cost of goods sold of $875 and inventory of $2,100.
- COGS = $1,700
- Inventory = $1,275
- COGS = $875
- Inventory = $2,100
Therefore, we can see that the financial statements for COGS and inventory depend on the inventory valuation method used. Using Last-In First-Out, there are more costs expensed and less costs in inventory. As discussed below, it creates several implications on a company’s financial statements.
Impact of LIFO Inventory Valuation Method on Financial Statements
Recall the comparison example of Last-In First-Out and another inventory valuation method, FIFO. The two methods yield different inventory and COGS.
1. Low quality of balance sheet valuation
By using LIFO, the balance sheet shows lower quality information about inventory. It expenses the newest purchases first thus leaving older, outdated costs on the balance sheet as inventory.
For example, consider a company with a beginning inventory of two snowmobiles at a unit cost of $50,000. The company purchases another snowmobile for a price of $75,000. For the sale of one snowmobile, the company will expense the cost of the newer snowmobile $75,000. Therefore, it will provide lower-quality information on the balance sheet compared to other inventory valuation methods as the cost of the older snowmobile is an outdated cost compared to current snowmobile costs.
2. High quality of income statement matching
Since LIFO expenses the newest costs, there is excellent matching on the income statement. The revenue from the sale of inventory is matched with the cost of the more recent inventory cost.
For example, consider a company with a beginning inventory of 100 calculators at a unit cost of $5. The company purchases another 100 units of calculators at a higher unit cost of $10 due to the scarcity of materials used to manufacture the calculators. If the company made a sale of 50 units of calculators, under the LIFO method, the most recent calculator costs would be matched with the revenue generated from the sale. It would provide excellent matching of revenue and cost of goods sold on the income statement.
LIFO in Accounting Standards
Under IFRS and ASPE, the use of the last-in, first-out method is prohibited. However, under GAAP, the use of Last-In First-Out is permitted. The inventory valuation method is prohibited under IFRS and ASPE due to potential distortions on a company’s profitability and financial statements.
The revision of IAS Inventories in 2003 prohibited LIFO from being used to prepare and present financial statements. One of the reasons is that it can lead to a reduction in tax burden in the case of inflating prices. Recall the example we did above and assume that the sales price of a unit of inventory is $15:
- COGS = $1,700
- Revenue = 350 x $15 = $5,250
Gross profits under LIFO = $5,520 – $1,700 = $3,820
- COGS = $875
- Revenue = 350 x $15 = $5,250
Gross profits under FIFO = $5,520 – $875 = $4,645
Under LIFO, the company reported a lower gross profit even though the sales price was the same. Now, it may seem counterintuitive for a company to underreport profits. However, by using LIFO, the cost of goods sold is reported at a higher amount, resulting in a lower profit and thus a lower tax. Therefore, it can be used as a tool to save on tax expenses.
However, the main reason for discontinuing the use of LIFO under IFRS and ASPE is the use of outdated information on the balance sheet. Recall that with the LIFO method, there is a low quality of balance sheet valuation. Therefore, the balance sheet may contain outdated costs that are not relevant for users of financial statements.