Last in, first out (LIFO) is a method used to account for how inventory has been sold that records the most recently produced items as sold first. This method is banned under the International Financial Reporting Standards (IFRS), the accounting rules followed in the European Union (EU), Japan, Russia, Canada, India, and many other countries. The U.S. is the only country that allows last in, first out (LIFO) because it adheres to Generally Accepted Accounting Principles (GAAP).
There are two alternatives to last in, first out (LIFO) for inventory costing: first in, first out (FIFO) and the average cost method. In first in, first out (FIFO), the oldest inventory items are recorded as sold first. The average cost method takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the cost of goods sold (COGS) and ending inventory.
Key Takeaway
- Last in, first out (LIFO) is a method used to account for how inventory has been sold that records the most recently produced items as sold first.
- The U.S. is the only country that allows LIFO because it adheres to Generally Accepted Accounting Principles (GAAP), rather than the International Financial Reporting Standards (IFRS), the accounting rules followed in the European Union (EU), Japan, Russia, Canada, India, and many other countries.
- Virtually any industry that faces rising costs can benefit from using LIFO cost accounting.
When prices are rising, it can be advantageous for companies to use LIFO because they can take advantage of lower taxes. Many companies that have large inventories use LIFO, such as retailers or automobile dealerships.
How Last in, First out (LIFO) Works
Under LIFO, a business records its newest products and inventory as the first items sold. The opposite method is FIFO, where the oldest inventory is recorded as the first sold. While the business may not be literally selling the newest or oldest inventory, it uses this assumption for cost accounting purposes. If the cost of buying inventory were the same every year, it would make no difference whether a business used the LIFO or the FIFO methods. But costs do change because, for many products, the price rises every year.
Companies That Benefit From LIFO Cost Accounting
Businesses that sell products that rise in price every year benefit from using LIFO. When prices are rising, a business that uses LIFO can better match their revenues to their latest costs. A business can also save on taxes that would have been accrued under other forms of cost accounting, and they can undertake fewer inventory write-downs.
Virtually any industry that faces rising costs can benefit from using LIFO cost accounting. For example, many supermarkets and pharmacies use LIFO cost accounting because almost every good they stock experiences inflation. Many convenience stores—especially those that carry fuel and tobacco—elect to use LIFO because the costs of these products have risen substantially over time.
Criticism of LIFO
Opponents of LIFO say that it distorts inventory figures on thebalance sheet in times of high inflation. They also point out that LIFO gives its users an unfair tax break because it can lower net income, and subsequently, lower the taxes a firm faces.
Example of LIFO
Suppose there's a companycalled One Cup, Inc. that buys coffee mugs from wholesalers and sells them on the internet. One Cup'scost of goods sold (COGS) differswhen it uses LIFO versus when it uses FIFO. In the first scenario, the price of wholesale mugs is rising from 2016 to 2019. In the second scenario, prices are falling between the years 2016 and 2019.
Rising Prices
Year | Number of Mugs Purchased from Wholesaler | Cost per Mug | Total Cost |
2016 | 100 | $1.00 | $100 |
2017 | 100 | $1.05 | $105 |
2018 | 100 | $1.10 | $110 |
2019 | 100 | $1.15 | $115 |
Falling Prices
Year Purchased | Number of Mugs Purchased from Wholesaler | Cost per Mug | Total |
2016 | 100 | $1.00 | $100 |
2017 | 100 | $0.95 | $95 |
2018 | 100 | $0.90 | $90 |
2019 | 100 | $0.85 | $85 |
In 2020, One Cup sells 250 mugs on the internet. Under LIFO, COGS is equal to: the total cost of the 100 mugs purchased from the wholesaler in 2019, plus the cost of 100 mugs purchased in 2018, plus the cost of 50 of the 100 mugs purchased in 2017.
Under FIFO, COGS is equal to: the total cost of 100 mugs purchased in 2016, plus the cost of 100 mugs purchased in 2017, plus the cost of 50 of the 100 mugs purchased in 2018.
The third table demonstrates how COGS under LIFO and FIFO changes according to whether wholesale mug prices are rising or falling.
COGS During Rising Prices and Falling Prices Depending on Accounting Method
RISING PRICES | FALLING PRICES | |
FIFO | $260 | $240 |
LIFO | $277.5 | $222.5 |
During times of inflation, COGS is higher under LIFO than under FIFO. This is because the most recently purchased items are sold first: 100 units from 2019, 100 units from 2018, and 50 units from 2017.
Under FIFO, the oldest items are sold first: 100 units from 2016, 100 units from 2017,and 50 units from 2018. These prices are combined to make the 250-unit order.During times of falling prices, the opposite is true: the COGS is lower under LIFO and higher under FIFO.
Therefore, in times of inflation, the COGS under LIFO better represents the real-world cost of replacing the inventory. This is in accordance with what is referred to as the matching principle of accrual accounting.
LIFO Lowers Tax Bills During Inflation
The higher COGS under LIFO decreases net profits and thus creates a lower tax bill for One Cup. This is why LIFO is controversial; opponents argue that during times of inflation, LIFO grants an unfair tax holiday for companies. In response, proponents claim that any tax savings experienced by the firm are reinvested and are of no real consequence to the economy. Furthermore, proponents argue that a firm's tax bill when operating under FIFO is unfair (as a result of inflation).
Fewer Inventory Write-Downs Under LIFO
A final reason that companies elect to use LIFO is that there are fewer inventory write-downs under LIFO during times of inflation. An inventory write-down occurs when the inventory is deemed to have decreased in price below its carrying value.Under GAAP, inventory carrying amounts are recorded on the balance sheet at either the historical cost or the market cost, whichever is lower.
The market cost is constrained between an upper and lower bound: the net realizable value (the selling price less reasonable costs of completion and disposals) and the net realizable value minus normal profit margins. In inflationary conditions, the carrying amount of the inventories on a balance sheet already reflects the oldest costs of carrying and are the most conservative inventory values. Therefore, under LIFO, write-downs of inventory are usually unnecessary and rarely undertaken.
Moreover, because write-downs can reduce profitability (by increasing the costs of goods sold) and assets (by decreasing inventory), solvency, profitability, and liquidity ratios can all be negatively impacted. GAAP prohibits reversals of write-downs.As a result, firms that are subject to GAAP must ensure that all write-downs are absolutely necessary because they can have permanent consequences.
The Bottom Line: LIFO Reduces Taxes and Helps Match Revenue With Cost
During times of rising prices, companies may find it beneficial to use LIFO cost accounting over FIFO. Under LIFO,firms can save on taxes as well as better match their revenue to their latest costs when prices are rising.
Article Sources
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International Financial Reporting Standards (IFRS). "Who Uses IFRS Standards?"
American Institute of Certified Public Accountants. "Is IFRS That Different From U.S. GAAP?"
Internal Revenue Service. "Publication 538, Accounting Periods and Methods," Pages 14-15.
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