What is LIFO (Last In, First Out)?
An inventory costing method where the newest inventory items are sold or used first.
Explanation: LIFO (Last In, First Out) is an inventory costing method where the newest inventory items are sold or used first. This method assumes that the most recently acquired or produced items are the first to be used or sold, which impacts the cost of goods sold (COGS) and inventory valuation on financial statements.
Key Principles of LIFO
Newest Inventory First: Items that were acquired or produced most recently are sold or used before older inventory.Cost Flow Assumption: The cost associated with the most recent inventory items is used to calculate the cost of goods sold, while the remaining inventory reflects the cost of the older items.Inflation Impact: LIFO can result in higher COGS and lower reported profits during periods of inflation, as newer, more expensive inventory is matched against current sales revenue.Benefits of LIFO
Tax Advantages: Higher COGS under LIFO can lead to lower taxable income, resulting in tax savings during periods of rising prices.Matching Current Costs to Revenue: LIFO better matches current costs with current revenues, providing a more accurate representation of profitability in inflationary environments.Cash Flow Improvement: The tax deferral resulting from lower taxable income can improve a company’s cash flow.Challenges of LIFO
Inventory Valuation: LIFO can result in outdated inventory values on the balance sheet, as older costs remain in inventory.Not Accepted Globally: LIFO is not allowed under International Financial Reporting Standards (IFRS), limiting its use to regions where Generally Accepted Accounting Principles (GAAP) apply, such as the United States.Complexity: Implementing and maintaining LIFO can be complex, particularly in tracking inventory layers and costs.Example of LIFO Calculation
Suppose a company has the following inventory transactions:
Beginning Inventory: 100 units at $10 eachPurchase 1: 200 units at $12 eachPurchase 2: 150 units at $15 eachIf the company sells 250 units, the cost of goods sold (COGS) would be calculated as follows:
1. First, sell the 150 units from Purchase 2:
150 units × $15 = $2,250
2. Next, sell 100 units from Purchase 1:
100 units × $12 = $1,200
Total COGS under LIFO:
$2,250 + $1,200 = $3,450
The remaining inventory would be:
100 units from the beginning inventory at $10 each100 units from Purchase 1 at $12 eachLIFO in Financial Statements
Income Statement: Under LIFO, the COGS will reflect the cost of newer inventory, potentially leading to higher COGS and lower gross profit and net income during periods of rising prices.Balance Sheet: The ending inventory will be valued based on the older costs, which may not reflect the current market value, resulting in lower inventory valuation on the balance sheet.LIFO is an inventory costing method that can offer significant tax benefits and better matching of current costs to revenues during inflationary periods. However, it also presents challenges such as complex implementation, outdated inventory values, and limited acceptance under global accounting standards. Businesses using LIFO must carefully consider these factors and maintain accurate records to effectively manage their inventory and financial reporting.
