Last in First Out (LIFO)

Cost AccountingFinancial Accounting

When Last in First Out (LIFO) is used, the assumption is made that each time a unit is sold it is the one that was purchased most recently—the newest item in inventory. Therefore, the oldest inventory items (and the lowest-cost items, assuming rising prices) will be included in ending inventory on the balance sheet.

In a period of rising prices LIFO will create a lower ending inventory balance and a higher COGS (and therefore lower operating income) when compared to FIFO. At year end, the oldest, lowest-cost items are still in inventory and the newest, highest cost units have been sold and are expensed on the income statement as cost of goods sold.

The LIFO inventory method can be compared to an elevator. Assume a crowd of people stepping onto an elevator and heading to the same floor together. The last person who steps on is often the first person stepping off because that person is closest to the door.

Under LIFO, cost of goods sold is valued at the current cost (or replacement cost) of the inventory. Inventory is recorded on the balance sheet at an older, historical cost. Therefore, the income statement has “current” figures on it because cost of goods sold is valued at the current costs.

LIFO Layers and LIFO Liquidations

When LIFO is being used, each purchase of merchandise for sale is a separate layer in inventory, and each layer has its own cost per unit. Selling 100% of a particular layer is called liquidating that layer. The layers are liquidated in the reverse order of their purchase. The most recent layer is liquidated before the next most recent layer is liquidated, and so forth.

When prices are rising, the price per unit of the older layers is lower than the price per unit of layers purchased more recently. Therefore, liquidating any layer means that the next sale must come from the next oldest layer, and the cost of the next sale will be lower because the inventory was purchased earlier at a lower price.

Therefore, liquidating last-in, first-out layers of inventory when prices have been increasing will lead to an increase in net income because the cost of the sales made from earlier layers of inventory will be lower, so net income will be higher.

Benefits of LIFO

  • LIFO is sometimes the best match for the way goods physically flow into and out of inventory. When new inventory is received and displayed for sale, items may be placed in front of the existing inventory unless a concerted effort is made to position newer items behind older ones. If newer items are consistently placed in front of older ones, the newest units are always the units sold.
  • LIFO better matches current costs against current revenues and therefore provides a better measure of current earnings. When prices are rising, use of LIFO leads to better quality earnings.
  • The primary advantage of LIFO is that when prices are rising the use of LIFO for tax reporting results in a higher cost of goods sold and a lower taxable income. Lower taxable income leads to lower income taxes and higher cash flow.

Limitations of LIFO

  • If a company uses LIFO for its tax reporting to gain the advantage of lower taxes, tax law in the U.S. requires that the company also use LIFO for its financial reporting. Therefore, the company’s reported earnings will be lower than they would be under the other cost flow assumptions, assuming rising prices. Tax law does not have a similar requirement for other inventory cost flow assumptions.
  • Since the items reported as inventory on the balance sheet will be the earliest items purchased, when prices rise inventory will be valued too low on the balance sheet.
  • If sales exceed purchases of inventory, layers of old inventory will be liquidated. The old costs will be matched against current revenues and will cause an increase in reported income for the period in which the liquidation occurs.
  • A company using LIFO may be able to manipulate its net income by altering its purchasing pattern at year end.
  • Accounting under LIFO can be complex because of the LIFO cost layers.
  • Using LIFO for inventory valuation is not permitted if a company is using IFRS.

LIFO in the Periodic System

LIFO in the periodic system is similar to FIFO in the periodic system except for the determination of which units are included in ending inventory and which units were sold during the period.

At the end of the period, the company determines the number of units of inventory it had available for sale during the period (beginning inventory plus inventory purchased during the period) and the cost of each of the units in beginning inventory and the units purchased during the period. The cost of the units sold is assumed to be the cost of the units most recently purchased during the period. If the number of units sold during the period is greater than the number of units purchased during the period, some units are sold from the beginning inventory at their cost in beginning inventory, using the most recently purchased units in the beginning inventory. Ending inventory consists of the oldest units on hand.

  • If inventory increased during the period, the ending inventory for the period is made up of the units that were in beginning inventory plus the units purchased closest to the beginning of the period.
  • If inventory decreased during the period, the ending inventory for the period consists of the remaining units in beginning inventory that are still unsold at the end of the period. All units that were purchased during the period are sold by the end of the period.

Again, the value of the ending inventory is determined only at the end of the period

LIFO in the Perpetual System

With perpetual LIFO, it is slightly more difficult to calculate the ending inventory because the LIFO inventory is in LIFO layers.

A LIFO layer arises when a company purchases more inventory before it sells all of its previously purchased inventory. The assumption underlying LIFO—the most recently purchased (newest) inventory item is always the first unit sold—leads to many different individual prices for the units in ending inventory. Each time the company buys more inventory before selling all the inventory it previously had on hand, a layer is added.

Once a LIFO layer is created, it will remain in place until the company reaches a period when it sells more units than it purchased during the period. When the company sells more units than it has purchased, one or more LIFO layers may be eliminated, a process called a “LIFO Liquidation.”

Each layer will remain in inventory until it is “liquidated.” The liquidation of a layer occurs when the company sells all of the most recently purchased inventory plus some “older” inventory before purchasing more. However, keep in mind that the liquidated layer will be the newest, most recently formed layer. Therefore, the first units of each inventory item that a company purchased could theoretically still be in the company’s inventory 50 or more years later.

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