What is the LIFO(Last In, First Out) method? Definition and Example.

LIFO method

LIFO is an abbreviation for ‘Last In First Out.’ It is a method of accounting for inventory that helps in calculating the cost of goods sold. This inventory accounting method assumes that the recent items added to the inventory are the ones sold first.

Here is what we’ll cover:

Why would you use LIFO?

The LIFO accounting method is used for calculating the cost of goods sold when the inventory has been increasing in terms of cost of production or acquiring; this may be the case due to inflation.

However, this inventory costing method represents fewer profits for a business, giving the advantage of deduction in taxes the company has to pay. A business can use the LIFO method to lower the taxes and increase the cash flows at higher prices. It is mostly used by businesses having extensive inventories such as retailers or auto dealerships.

Example of LIFO:

We here take an example of using LIFO as a method of accounting:

Maddy runs a DVD store selling movies, documentaries, etc., on DVDs. Maddy has three partners in his business who have invested, but Maddy alone handles daily operations related to his business. 

Maddy makes sure to have all the latest DVDs with a good quality picture running in the market to have more customer attraction. Nowadays, people are switching to online and digital technologies more often. Because of this situation, his inventory cost is also increasing day by day. 

The following table shows how Maddy has built up his inventory:

MonthAmountPrice Paid
October 3100$15
October 15100$15
October 28125$15.25
November 4150$15.5
November 17150$16.25
November 26150$17

On 31st December, Maddy looks at his inventory book and realizes that he has sold a total number of 450 DVDs to date. Now he has to make a record of the cost of goods sold to show his partners.

Maddy uses the LIFO method, which means taking the recent DVD price of $17. He cannot apply the rate of $17 to all 600 DVDs so that he will do the following way:

Calculation of Cost of goods sold:

150 DVDs x $17 =$2,550 (using price of Nov 26)
150 DVDs x $16.25 =$2,437.5 (price of Nov 17)
150 DVDs x $15.5 =$2,325 (the price of Nov 4)
Cost of goods sold:$7,312.5

The 450 DVDs are now no longer considered inventory; they are considered the cost of goods sold. The value of the remaining DVDs will stay in inventory.

The LIFO method shows that Maddy is selling off all of his latest DVDs. The latest stock means that Maddy is selling the DVDs according to the customer demand as they also look for the latest ones. The problem here is that the oldest stock will remain in the inventory forever as only the latest stock is being sold. Depending on the business’s nature, the older stock may become outdated or obsolete.

Is LIFO Illegal?

The United States can only use LIFO per permission stated by GAAP (General Accepted Accounting Principle).

All the companies/businesses follow the guideline given by GAAP for preparing financial statements. GAAP sets standards for a wide array of topics, from assets and liabilities to foreign currency and financial statement presentation. 

The LIFO method is prohibited outside the United States. Many countries, such as Canada, India, and Russia, must follow the rules set down by the IFRS (International Financial Reporting Standards) Foundation. The IFRS provides a framework for globally accepted accounting standards. 

What is the difference between LIFO and FIFO?

The LIFO is an abbreviation for ‘Last In First Out,’ this method of inventory assumes that the most current stock is sold out and is used for calculating the cost of goods sold.

The FIFO is an abbreviation for ‘First in First Out,’ this inventory method assumes that the oldest stock is sold out first, which is used to calculate the cost of goods sold.

Why is LIFO better than FIFO?

LIFO may not be better than FIFO as it depends on the market environment.

LIFO uses the latest inventory to be sold, which gives a higher cost of inventory. These costs are higher than the firstly produced and acquired inventory. Higher costs may result in lower taxes with LIFO. It also shows the difference between the two LIFO and FIFO that FIFO represents accurate profits as the older inventory tells the actual cost. Using FIFO could show the company’s natural profitability, which, if it were high, would attract the shareholders to invest in that company.

The LIFO method can be used by Americans and is attractive because companies may have to pay fewer taxes, but the net profit will also be less. This method is criticized because the old items remain in the inventory forever as per records. Also, the LIFO method is used technically, not a physical record of inventory, and so the items that are old in inventory can be sold. This shows that the cost of goods sold is not accurate. This method is controversial and is banned from use out of the United States. 

Businesses usually sell off the oldest items left in the inventory as they might become obsolete if not sold further. So FIFO follows the same way of going with the natural flow of inventory. If you want to have an accurate figure about your inventory, then FIFO is the better method.

What is LIFO Reserve?

The LIFO reserve is the amount by which a company’s taxable income has been deferred compared to the FIFO method. This is because when using the LIFO method, a business realizes smaller profits and pays fewer taxes.

LIFO, Inflation, and Net Income:

When there is zero inflation, all three inventory-costing methods produce the same result. But if inflation is high, the choice of accounting method can dramatically affect valuation ratios. FIFO, LIFO, and average cost have a different impacts:

  • FIFO provides a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value COGS. Increasing net income sounds good, but it can increase the taxes that a company must pay.
  • LIFO is not a good indicator of ending inventory value because it may understate the value of inventory. LIFO results in lower net income (and taxes) because COGS is higher. However, there are fewer inventory write-downs under LIFO during inflation.
  • Average cost produces results that fall somewhere between FIFO and LIFO.

If prices are decreasing, then the complete opposite of the above is true.

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