What Is LIFO Inventory and How Does It Work?
Learn about LIFO inventory, an accounting method for valuing goods sold and remaining stock, and its financial implications.
Businesses use various methods to manage and value inventory, directly impacting financial statements. These methods determine how the cost of goods is matched against sales revenue. Last-In, First-Out (LIFO) is one such inventory costing method. This article explains the LIFO method and its function in financial reporting.
Understanding the LIFO Concept
The LIFO method assumes the latest goods added to inventory are the first ones sold or used. This is a cost flow assumption, meaning it dictates how costs are assigned to products, rather than reflecting their physical movement. For example, a car dealership might physically sell older models first, but under LIFO, the cost assigned to the sale would be that of the most recently acquired vehicles.
The core principle of LIFO is that the costs of the most recently purchased inventory items are expensed first when a sale occurs. Consequently, the inventory remaining on the balance sheet consists of the oldest costs. While the physical flow of goods often aligns with a “First-In, First-Out” (FIFO) approach, LIFO remains a permissible accounting choice for cost assignment regardless of actual physical movement.
How LIFO Affects Inventory Valuation
The LIFO method assigns the costs of the newest inventory to the Cost of Goods Sold (COGS) and the oldest inventory to the ending inventory balance. When a sale occurs, the most recent purchase costs are removed from inventory and transferred to COGS. This impacts both the expense recognized on the income statement and the inventory value on the balance sheet.
Consider an electronics retailer with these tablet purchases: 10 tablets on January 1 at $200 each ($2,000 total), 15 tablets on February 15 at $210 each ($3,150 total), and 20 tablets on March 20 at $220 each ($4,400 total).
If the retailer sells 30 tablets on April 1, LIFO assigns costs from the most recent purchases. COGS would include 20 tablets from March 20 at $220 each ($4,400), and the remaining 10 from February 15 at $210 each ($2,100). Total COGS for this sale would be $6,500.
Ending inventory would consist of the remaining tablets from the earliest purchases: 10 tablets from January 1 at $200 each ($2,000) and 5 tablets from February 15 at $210 each ($1,050). This results in an ending inventory value of $3,050.
Financial Reporting Under LIFO
The LIFO method has distinct consequences for a company’s financial statements, particularly the income statement and balance sheet. In periods when inventory costs are rising, LIFO results in a higher Cost of Goods Sold compared to other inventory methods. This higher expense directly leads to a lower reported gross profit and, consequently, a lower net income on the income statement.
On the balance sheet, using LIFO results in a lower reported inventory asset value. This occurs because the most recent, and often higher, inventory costs are expensed as goods are sold, leaving the older, lower costs in the ending inventory balance. Therefore, in an inflationary environment, the inventory value shown on the balance sheet may not reflect the current replacement cost of the goods on hand.
The lower net income reported under LIFO, especially during inflationary periods, can also translate into a lower tax liability for the company. While advantageous for tax purposes, this means financial statements presented to shareholders will show reduced profitability. This trade-off between tax benefits and reported earnings is a significant consideration for companies choosing LIFO.
LIFO Rules and Usage
Companies in the United States must adhere to specific rules when electing to use the LIFO inventory method. A primary regulation is the “LIFO conformity rule,” stipulated in Internal Revenue Code Section 472. This rule mandates that if a company uses LIFO for federal income tax purposes, it must also use LIFO for financial reporting to shareholders and for credit purposes. The intent is to prevent businesses from reporting lower profits for tax purposes while presenting higher profits to investors under a different inventory method.
To elect the LIFO method, a taxpayer files Form 970, Application to Use LIFO Inventory Method, with their tax return. Once a company adopts LIFO for tax purposes, switching back to another inventory method requires approval from the Internal Revenue Service (IRS). While LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP), it is explicitly prohibited under International Financial Reporting Standards (IFRS). IFRS disallows LIFO due to concerns that it can distort profitability and lead to outdated inventory valuations on the balance sheet.