What Is the LIFO Method and How Does It Work?

Businesses must account for inventory value and the cost of goods sold (COGS), as these valuations affect financial statements and profitability. The Last-In, First-Out (LIFO) method is one approach to determine which inventory costs are recognized first when sales occur.

Defining LIFO

LIFO, or Last-In, First-Out, is an inventory costing method that assumes the most recently purchased or produced inventory items are the first ones sold. This means the cost of newer goods acquired by a business is expensed as cost of goods sold before older inventory. LIFO is an accounting assumption about cost flow, not the physical movement of goods.

In the United States, LIFO is permitted under Generally Accepted Accounting Principles (GAAP). However, International Financial Reporting Standards (IFRS), used by most other countries, explicitly prohibit LIFO. IFRS disallows LIFO because it can lead to outdated inventory values on the balance sheet, as the oldest costs remain, potentially distorting profitability.

How LIFO is Applied

Applying the LIFO method involves tracking inventory costs as they are acquired and then assigning the most recent costs to sales. For example, a company sells 150 units of a product. Initially, the company purchased 100 units at $10 each on January 1, totaling $1,000. Later, on February 1, it purchased another 100 units at $12 each, costing $1,200.

When the company sells 150 units, LIFO dictates that the cost of goods sold will be calculated using the most recent purchases first. Therefore, the 100 units purchased on February 1 at $12 each ($1,200) would be expensed. The remaining 50 units sold would come from the January 1 purchase at $10 each ($500). This results in a total cost of goods sold of $1,700 ($1,200 + $500).

After this sale, the ending inventory consists of the remaining 50 units from the January 1 purchase, valued at $10 each, totaling $500. This example illustrates how LIFO prioritizes the latest costs for sales, leaving older costs to represent the value of the remaining inventory on the balance sheet.

Impact of LIFO on Financial Reporting

LIFO significantly influences a company’s financial statements. In an inflationary environment, LIFO typically results in a higher Cost of Goods Sold (COGS) because the most expensive, recently acquired inventory is expensed first against revenue. A higher COGS leads to a lower reported gross profit and, consequently, a lower net income.

Conversely, during periods of inflation, the value of ending inventory under LIFO is generally lower on the balance sheet. This is because the older, lower-cost inventory layers are assumed to remain in stock. The lower reported net income under LIFO can lead to reduced taxable income, which in turn results in lower tax payments. This tax benefit is a primary reason many U.S. companies opt for the LIFO method, especially during sustained inflationary periods.

Internal Revenue Code Section 472(c) enforces the LIFO conformity rule in the United States. This rule mandates that if a company uses LIFO for tax purposes, it must also use LIFO for financial reporting to shareholders and investors. This prevents companies from presenting higher profits to shareholders using other methods, while simultaneously minimizing their tax liability with LIFO.

Understanding LIFO Liquidation

LIFO liquidation occurs when a company sells more inventory than it purchases or produces in a given period. This forces the company to sell older, lower-cost inventory layers that have accumulated in its inventory. This can arise due to unexpected surges in customer demand or disruptions in the supply chain that limit new inventory acquisitions.

When older, lower-cost inventory layers are sold, they are matched against current revenues, leading to an artificially reduced cost of goods sold. This results in an inflated gross profit and net income for that period. While this might seem beneficial, it can lead to a higher taxable income and a larger tax bill, effectively negating the tax advantages typically associated with LIFO in an inflationary environment.

LIFO liquidation can distort a company’s true operating performance. The higher profits are not a result of improved operational efficiency but rather the depletion of historically cheaper inventory. Accounting standards often require companies to disclose the impact of LIFO liquidations on net income and earnings per share. This disclosure helps stakeholders understand that such gains may be non-recurring and not indicative of sustainable profitability.