What Does LIFO Mean in Accounting and for Taxes?
Understand how LIFO, an inventory method, shapes a company's financial reporting and tax liabilities.
LIFO, which stands for Last-In, First-Out, is an inventory accounting method businesses use to determine the cost of goods sold and the value of their remaining inventory. Its primary purpose is to match the most recent costs of acquiring inventory against the revenue generated from sales.
Understanding the LIFO Method
The LIFO method assumes that the most recently purchased inventory items are the first ones sold. This means the cost assigned to a sale comes from the newest inventory acquired. The remaining inventory consists of the oldest items on hand.
This method directly impacts the calculation of the Cost of Goods Sold (COGS) and the valuation of ending inventory on a company’s financial statements. It is primarily used in the United States and is allowed under Generally Accepted Accounting Principles (GAAP).
Applying LIFO in Practice
Consider an electronics retailer selling headphones. On January 1, they have 10 units at $50 each. On January 15, they purchase 15 units at $55 each. On January 25, they acquire 20 more units at $60 each.
If the retailer sells 30 units in January, the LIFO method assumes the last ones in are the first ones out. The Cost of Goods Sold (COGS) includes the 20 units from January 25 at $60 each ($1,200). The remaining 10 units sold come from the January 15 purchase at $55 each ($550).
The total COGS for January is $1,750 ($1,200 + $550). Ending inventory consists of the remaining 5 units from the January 15 purchase ($55 each) and the original 10 units from January 1 ($50 each). This results in an ending inventory value of $275 (5 units x $55) plus $500 (10 units x $50), for a total of $775. This example illustrates how LIFO assigns higher, more recent costs to sales during periods of rising prices, leaving older, lower costs in inventory.
Impact on Financial Reporting and Taxes
The LIFO method significantly influences a company’s financial statements, particularly the income statement and balance sheet. During periods of rising inventory costs, LIFO results in a higher Cost of Goods Sold (COGS) because it expenses the most recent, more expensive inventory first. A higher COGS leads to a lower reported gross profit and, consequently, a lower net income.
Conversely, during periods of declining inventory costs, LIFO results in a lower COGS and a higher reported net income. The balance sheet impact under LIFO means that ending inventory is valued at older, lower costs, which can make the inventory value appear outdated compared to current market prices. This contrasts with methods like FIFO, where ending inventory reflects more current costs during inflation.
A compelling reason for businesses to choose LIFO, particularly in inflationary environments, is the potential for tax savings. By reporting a higher COGS and lower net income, a company’s taxable income is reduced, leading to a lower tax liability. The Internal Revenue Service (IRS) enforces a “LIFO conformity rule” (Internal Revenue Code Section 472). This rule requires that if a company uses LIFO for tax purposes, it must also use LIFO for financial reporting to shareholders. This prevents companies from presenting higher profits to investors while simultaneously reporting lower profits to the IRS to minimize taxes.
Key Considerations for LIFO Users
Businesses often consider LIFO for its ability to reduce taxable income during periods of inflation, which can provide a cash flow advantage by lowering immediate tax payments. This method aligns current costs with current revenues on the income statement, which some consider a better matching of expenses to sales.
A significant consideration for companies is that LIFO is not permitted under International Financial Reporting Standards (IFRS). IFRS, used in many countries worldwide, prohibits LIFO due to concerns that it can distort a company’s profitability and financial statements, especially when inventory levels fluctuate. This prohibition is a substantial factor for multinational companies or those considering adopting IFRS, as they cannot use LIFO for their IFRS financial statements.
Companies using LIFO are required to disclose a “LIFO reserve.” This reserve represents the difference between the inventory value under LIFO and what it would have been under another method, typically FIFO. This disclosure helps financial statement users understand the impact of the LIFO method on the reported inventory balance and net income.