What is last in first out (LIFO) in accounting?

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Effective inventory management is essential for a company's financial health, particularly when it comes to tax savings and accurate financial reporting. One method that plays a significant role in accounting is Last-In, First-Out (LIFO). 

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Recognized under U.S. Generally Accepted Accounting Principles (GAAP), LIFO assumes that the most recently acquired items are sold first, impacting how costs are calculated and reported.

What is LIFO?

Last-In, First-Out (LIFO) is an inventory valuation method used primarily in the United States. Under LIFO, it is assumed that the latest goods added to inventory are sold before the older stock. This means the cost of goods sold (COGS) is calculated using the costs of the most recent purchases, while older inventory costs remain on the balance sheet. 

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Put differently, LIFO treats the newest inventory items as the first ones sold, so the costs of the latest purchases are the first to be expensed. This approach reflects current market conditions in the cost of goods sold and leaves the oldest costs on the balance sheet as inventory.

LIFO example

Consider an electronics retailer that purchases 100 units of a gadget at $10 each, totaling $1,000. Later, due to market fluctuations, the cost increases, and the retailer buys another 100 units at $12 each, totaling $1,200.

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The retailer now has 200 units in inventory, with a combined cost of $2,200.

If the retailer sells 150 units, under the LIFO method, it assumes that the most recent units purchased are sold first. Therefore:

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• First 100 units sold: 100 units × $12 = $1,200
• Next 50 units sold: 50 units × $10 = $500
• Total COGS: $1,200 + $500 = $1,700

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Assuming the gadgets are sold at $15 each, the total revenue from selling 150 units is:

• $15 × 150 units = $2,250

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The gross profit is calculated as:

• Total Revenue ($2,250) – COGS ($1,700) = Gross Profit ($550)

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The remaining inventory consists of 50 units from the initial $10 purchase, valued at:

• 50 units × $10 = $500

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Under LIFO, the higher recent costs are matched against current revenues, leading to a higher COGS and lower gross profit compared to other methods like First-In, First-Out (FIFO).

Advantages of LIFO

While LIFO is just one of several inventory accounting methods, it offers unique benefits that can significantly impact a company's financial performance and strategy.

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• Tax benefits - One of the primary advantages of LIFO is the potential for tax savings. During periods of inflation, when the cost of inventory is rising, using LIFO results in a higher COGS. A higher COGS reduces the gross profit and, consequently, the taxable income. This can lead to significant tax savings, allowing businesses to retain more cash for operational needs.
• Improved cash flow - By reducing taxable income, LIFO can enhance a company's cash flow. The tax savings generated provide additional liquidity, which can be used for reinvestment, paying down debt, or other operational expenses. This improved cash flow contributes to the overall liquidity in business, enabling companies to maintain financial flexibility.
• Financial reporting accuracy - LIFO matches recent inventory costs with current revenues, providing a more accurate reflection of a company's earnings in an inflationary environment. This method ensures the income statement reflects the current cost environment, which can be informative for stakeholders analyzing the company's performance.

Disadvantages of LIFO

On the other hand, LIFO has a few drawbacks too:

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• Potential for outdated inventory valuations - While LIFO impacts the income statement favorably in terms of tax savings, it can result in outdated inventory valuations on the balance sheet. Since older inventory costs remain, the value of inventory assets may be understated, not reflecting current market prices. This can misrepresent the company's financial position to investors and creditors.
• Complexity and compliance - Implementing LIFO can add complexity to accounting processes. It requires meticulous record-keeping to track inventory layers and costs over time. Additionally, LIFO is permitted under U.S. GAAP but prohibited under International Financial Reporting Standards (IFRS). Companies operating internationally may face challenges, as they cannot use LIFO for financial reporting in countries that follow IFRS, potentially necessitating multiple accounting systems.
• Financial ratios impact - Using LIFO can affect financial ratios by reducing net income and lowering inventory values. Profitability ratios, such as gross profit margin and net profit margin, may appear less favorable, which could impact perceptions by investors or affect compliance with loan covenants tied to financial metrics.

Types of LIFO methods

LIFO can be implemented using different methods depending on the nature of the business and its specific inventory characteristics. The primary types of LIFO computation methods include the Internal LIFO Calculation Method, Automotive LIFO, and the Inventory Price Index Computation (IPIC) Method.

Internal LIFO calculation method

The Internal LIFO Calculation Method, also known as the Specific Goods LIFO Method, involves internally calculating LIFO inventory layers based on the company's own detailed inventory records. 

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This method requires meticulous tracking of individual inventory items, making it suitable for businesses that can precisely identify and measure their inventory costs, such as manufacturers and retailers with sophisticated inventory management systems. 

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By using this method, companies can accurately reflect their inventory costs and better match costs with revenues.

Automotive LIFO

Automotive LIFO is a specialized method designed for automobile dealerships. Given the unique nature of automotive inventory, which includes a wide variety of models, makes, and options with prices that frequently change due to manufacturer updates and market demand, dealerships adopt Automotive LIFO to effectively manage their inventory costs. 

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This method accounts for the manufacturer's price changes and helps dealerships match the most recent inventory costs with current sales. By doing so, it provides tax benefits and offers a more accurate financial picture of the dealership's operations.

Inventory price index computation (IPIC) method

The Inventory Price Index Computation (IPIC) Method is an IRS-approved method that utilizes external price indexes, such as the Consumer Price Index (CPI), to adjust inventory costs for inflation. Businesses with large and diverse inventories, like wholesalers and retailers with numerous inventory items, often opt for the IPIC Method. 

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This method simplifies the LIFO calculation process by avoiding the need to track the cost of each individual item. Instead, companies group inventory items into pools and apply the appropriate price index to adjust the inventory costs. By reflecting inflationary trends, the IPIC Method can result in potential tax advantages and provide a more accurate valuation of inventory in an inflationary economy.

Choosing the right LIFO method

The choice of LIFO method depends on several factors, including the nature of the inventory, the size of the business, and the level of detail in inventory tracking systems. Manufacturers and retailers with the capability to track individual inventory items may benefit from the Internal LIFO Calculation Method. 

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Automobile dealerships, due to their specialized inventory, typically use Automotive LIFO. Large wholesalers and retailers with extensive inventories may find the IPIC Method more practical due to its simplified approach to adjusting for inflation.

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Understanding inventory valuation methods can help businesses choose the most appropriate LIFO method for their operations.

Electing to use LIFO: Requirements and regulations

For a company to adopt the Last-In, First-Out (LIFO) inventory accounting method, it must follow specific procedures and comply with regulations set forth by the Internal Revenue Service (IRS). 

Filing form 970

To elect LIFO, a company must file Form 970, Application to Use LIFO Inventory Method, with the IRS. This form must be attached to the company's federal income tax return for the first tax year in which LIFO is used for any inventory items. 

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Filing Form 970 notifies the IRS of the company's intention to adopt the LIFO method and provides details about the inventory items and LIFO methods to be used.

Timing of the election

The election to use LIFO must be made by the due date, including extensions, of the federal tax return for the year in which the method is first used. Failing to file Form 970 on time generally means the company cannot use the LIFO method for that tax year and may need to wait until the following year to make the election.

Consistency requirements

Once a company elects to use LIFO for tax purposes, it must apply the method consistently across all financial reporting. This includes using LIFO for both federal tax purposes and financial statements provided to shareholders, creditors, and other stakeholders. The IRS requires consistency to prevent discrepancies between tax reporting and financial reporting.

Adequate record-keeping

Companies using LIFO must maintain detailed records to substantiate their inventory calculations. This includes tracking inventory layers, costs, and quantities of goods purchased and sold. 

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Adequate record-keeping ensures accurate computation of the cost of goods sold and ending inventory under the LIFO method and is essential for IRS compliance.

IRS Approval for method changes

After electing LIFO, a company cannot change to another inventory accounting method without obtaining permission from the IRS. To change methods, the company must file Form 3115, Application for Change in Accounting Method, and receive IRS consent. 

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This requirement ensures that changes in accounting methods are properly reviewed and approved by the IRS.

Compliance with GAAP

For companies that follow U.S. Generally Accepted Accounting Principles (GAAP), using LIFO is permissible. However, it's important to note that LIFO is not allowed under International Financial Reporting Standards (IFRS). 

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Companies that prepare financial statements under IFRS cannot use LIFO, and those operating internationally may need to maintain different accounting methods for different jurisdictions.

Understanding LIFO reserves

The LIFO Reserve is the difference between the inventory costs calculated under the Last-In, First-Out (LIFO) method and those calculated under the First-In, First-Out (FIFO) method.

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This reserve essentially reflects the amount by which a company's taxable income has been deferred by using LIFO instead of FIFO, providing valuable insights into the impact of inventory accounting methods on financial statements.

LIFO reserve example

Consider a company that uses the LIFO method for its inventory accounting. Over time, prices of the inventory items have been increasing due to inflation. 

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Suppose the company's inventory cost under LIFO is reported at $500,000. If the same inventory were accounted for under FIFO, the inventory cost would be $650,000.

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The LIFO Reserve in this case is calculated as:

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• LIFO Reserve = FIFO Inventory Value – LIFO Inventory Value
• LIFO Reserve = $650,000 – $500,000 = $150,000

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This $150,000 LIFO Reserve indicates the cumulative difference in the cost of inventory between the two accounting methods. It represents the amount by which the company's gross profit and taxable income have been reduced over time by using LIFO.

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The LIFO Reserve is significant for several reasons:

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• Comparability: Investors and analysts use the LIFO Reserve to adjust financial statements for better comparability between companies using different inventory accounting methods. By adding the LIFO Reserve back to the LIFO inventory value, one can estimate what the inventory would be under FIFO, facilitating apples-to-apples comparisons.
• Tax Implications: The LIFO Reserve also indicates the tax benefits a company has realized by using LIFO. The larger the reserve, the more the company has potentially deferred in taxes due to higher COGS under LIFO.
• Financial Analysis: Changes in the LIFO Reserve over time can provide insights into inflationary pressures on inventory costs and the company's inventory management strategies.

Adjusting financial statements using LIFO reserve

Analysts often adjust the financial statements of LIFO-reporting companies to the FIFO basis to enhance comparability. For example, to adjust the inventory balance to FIFO:

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• FIFO Inventory = LIFO Inventory + LIFO Reserve
• Using our earlier example: $500,000 + $150,000 = $650,000

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Similarly, the adjustment can affect the cost of goods sold (COGS) and net income:

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• FIFO COGS = LIFO COGS – Change in LIFO Reserve

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Understanding and utilizing the LIFO Reserve allows stakeholders to make more informed decisions by providing a clearer picture of a company's financial position under different inventory accounting methods. 

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For further financial analysis, businesses may also focus on calculating retained earnings to understand how inventory accounting methods impact overall equity.

Comparing LIFO and FIFO

In inventory accounting, First-In, First-Out (FIFO) is another commonly used method, which contrasts with the Last-In, First-Out (LIFO) approach. Understanding the differences between LIFO and FIFO is crucial for businesses as the choice of inventory accounting method can significantly affect financial statements, tax liabilities, and decision-making processes.

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First-In, First-Out (FIFO) is an inventory valuation method where it is assumed that the earliest goods purchased or manufactured are sold first. Under FIFO, the cost of goods sold (COGS) is calculated using the costs of the oldest inventory, while the costs of the most recent purchases remain in the ending inventory on the balance sheet.

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This method reflects the physical flow of many businesses' inventory, where older stock is sold before newer stock to prevent obsolescence and spoilage, especially in industries dealing with perishable goods.

LIFO vs. FIFO: Key differences

The following table outlines the primary differences between LIFO and FIFO inventory accounting methods:

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Impact of Inflation on LIFO and net income

The choice between LIFO and FIFO can have significant effects on a company's financial statements during periods of inflation. Under inflationary conditions, the cost of purchasing inventory rises over time. 

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This impacts COGS and net income differently under each method:

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• LIFO: Matches higher recent costs with current revenues, resulting in a higher COGS. This lowers the gross profit and net income, which can reduce taxable income and provide tax benefits.
• FIFO: Matches older, lower costs with current revenues, resulting in a lower COGS. This increases the gross profit and net income, potentially leading to higher taxes.

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Consider a company that purchased inventory as follows:

• January: 1,000 units at $10 each
• February: 1,000 units at $12 each
• March: 1,000 units at $14 each

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During the quarter, the company sold 2,000 units at $20 each. Let's compare the outcomes under LIFO and FIFO:

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Under LIFO:

• COGS:
  
  • First 1,000 units sold from March purchases: 1,000 units × $14 = $14,000
  • Next 1,000 units sold from February purchases: 1,000 units × $12 = $12,000
  • Total COGS: $14,000 + $12,000 = $26,000
• Total Revenue: 2,000 units × $20 = $40,000
• Gross Profit: $40,000 – $26,000 = $14,000
• Ending Inventory: Remaining 1,000 units from January purchases at $10 each = $10,000

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Under FIFO:

• COGS:
  
  • First 1,000 units sold from January purchases: 1,000 units × $10 = $10,000
  • Next 1,000 units sold from February purchases: 1,000 units × $12 = $12,000
  • Total COGS: $10,000 + $12,000 = $22,000
• Total Revenue: 2,000 units × $20 = $40,000
• Gross Profit: $40,000 – $22,000 = $18,000
• Ending Inventory: Remaining 1,000 units from March purchases at $14 each = $14,000

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Comparison:

• Gross Profit under LIFO: $14,000
• Gross Profit under FIFO: $18,000
• Difference: $4,000 higher under FIFO

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Understanding the differences between accounting methods is crucial, whether it's between LIFO and FIFO or a cash Vs. accrual accounting comparison, as these choices can significantly impact net income and tax liabilities during inflation.

Choosing Between LIFO and FIFO

Companies must consider several factors when choosing between LIFO and FIFO:

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• Tax Implications: LIFO can offer tax advantages during inflationary periods due to lower reported net income.
• Financial Reporting: FIFO can present a stronger financial position with higher net income and asset valuations.
• Regulatory Compliance: LIFO is permitted under U.S. GAAP but not under IFRS, affecting multinational corporations.
• Operational Reality: FIFO may better reflect the physical flow of goods for certain industries.

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Ultimately, the choice depends on the company's financial strategy, tax planning, and compliance requirements.

Keep track of your inventory with Ramp

Managing your inventory, and choosing the right way to account for it, is crucial for the success and growth of your business. At Ramp, we provide a comprehensive and automated finance platform to help you track your inventory accurately. Our accounting automation allows you to effortlessly streamline inventory tracking by managing data, reconciling transactions, and generating reports. 

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With Ramp, you can gain insights into your inventory performance and keep track of your costs in real time.