Last In, First Out (LIFO)

Last in, first out (LIFO) is a method of assigning costs to inventory that assumes the most recently purchased or produced units are the first ones sold. Under LIFO, cost of goods sold is based on the latest costs, while the inventory remaining at the end of the period is valued at the oldest costs, which may date back many years. Like other methods, LIFO is a cost flow assumption that does not need to match the physical movement of goods; a grocer using LIFO still sells its oldest milk first.

LIFO is permitted under US GAAP but prohibited under International Financial Reporting Standards, which allow only first in, first out, weighted average and specific identification. It is used mainly by US companies in industries with large inventories whose costs tend to rise over time, such as oil refining, chemicals, steel, wholesale distribution and car dealerships.

A hardware store starts March with 100 drills costing $40 each, buys 200 more at $44 and later 150 at $48, and sells 320 drills during the month at $70 each. Using periodic LIFO:

• Goods available for sale total 450 units costing $20,000.
• The 320 units sold are assumed to be the 150 most recent units at $48 ($7,200) and 170 of the units at $44 ($7,480), so cost of goods sold is $14,680.
• Ending inventory is the remaining 30 units at $44 ($1,320) and the original 100 at $40 ($4,000), a total of $5,320.
• Sales are $22,400, so gross profit is $7,720.

Using FIFO on the same facts, cost of goods sold would be $13,760 and gross profit $8,640. In this period of rising prices, LIFO reports $920 less profit and $920 lower inventory.

The main attraction of LIFO in the United States is tax. When prices are rising, higher cost of goods sold means lower taxable income and lower income tax, and the saving is deferred for as long as inventory levels are maintained. Supporters also argue that LIFO gives a better measure of current profit, because it matches current revenue with current costs and strips out inventory holding gains during periods of inflation.

Under US tax law, a company that uses LIFO for its tax return must also use it in its financial statements to shareholders and creditors, a requirement known as the LIFO conformity rule. This is why the choice affects published profits as well as taxes.

Because LIFO inventory can be valued at very old costs, its balance sheet figure may be far below current value. Companies therefore disclose a LIFO reserve, the difference between inventory at FIFO or current cost and inventory at LIFO. Analysts add the reserve back to compare LIFO companies with FIFO companies, and the change in the reserve during the year shows how much LIFO lowered pre-tax income.

A LIFO liquidation occurs when a company sells more inventory than it buys in a period, dipping into older, low-cost layers. Those old costs flow into cost of goods sold, temporarily boosting profit and triggering tax that had been deferred. Companies must disclose the effect of material liquidations, since the resulting profit is not sustainable and could be used to manage earnings.

Critics say LIFO produces an unrealistic balance sheet, with inventory shown at costs that may be decades old, which distorts working capital and ratios such as inventory turnover. It can also encourage poor purchasing decisions, such as buying extra stock at year end to avoid a liquidation. The International Accounting Standards Board removed LIFO from IAS 2 in 2003, effective 2005, largely for these reasons. Because US companies cannot use LIFO for tax without using it in their books, the prohibition is often cited as a barrier to US adoption of IFRS. Proposals to repeal LIFO for tax purposes have been made repeatedly but not enacted. Whichever method is used must be disclosed in the accounting policies note, and LIFO inventory remains subject to impairment testing under the lower of cost or market rule.