What Is the LIFO Method of Inventory Valuation?

The Last-In, First-Out (LIFO) method is an accounting assumption used to determine the cost of goods sold and the value of inventory remaining at the end of an accounting period. It is one of several inventory costing methods used for financial reporting and inventory management. LIFO is permissible under U.S. Generally Accepted Accounting Principles (GAAP), but it is not allowed under International Financial Reporting Standards (IFRS) used in many other countries.

The LIFO Principle and Application

The core principle of LIFO assumes that the most recently purchased or produced inventory items are the first ones sold, regardless of their actual physical flow. This means that the cost of the latest inventory acquisitions is matched against current revenue when calculating the cost of goods sold (COGS). Conversely, the inventory that remains on the balance sheet is assumed to consist of the oldest, earliest-acquired items.

To illustrate, under the LIFO method, when a business sells items, the cost of the most recent purchases is applied first to the goods sold. The remaining inventory is then valued based on the cost of the oldest items. This contrasts with other methods, such as First-In, First-Out (FIFO), where the oldest inventory would be assumed sold first.

Financial Reporting Implications

During periods of rising inventory costs, which is common in an inflationary environment, LIFO results in a higher Cost of Goods Sold (COGS) because it assumes the more expensive, recently acquired inventory is sold first. A higher COGS leads to a lower reported gross profit and, consequently, a lower net income. This can provide a tax advantage by reducing taxable income and therefore lowering income tax liabilities.

Conversely, the reported value of inventory on the balance sheet under LIFO tends to be lower during inflationary periods. This is because the older, lower-cost inventory items are assumed to remain unsold and are thus reflected as the ending inventory balance. While LIFO can offer tax benefits, it requires consistent application once adopted, and companies must adhere to accounting regulations.

LIFO Reserve and LIFO Liquidation

The LIFO reserve and LIFO liquidation are two concepts associated with the LIFO method. The LIFO reserve represents the difference between the inventory value reported under LIFO and the inventory value that would have been reported if a non-LIFO method, typically FIFO, had been used. Companies using LIFO are generally required under U.S. GAAP to disclose this reserve in the notes to their financial statements, providing transparency for financial statement users to compare companies using different inventory methods. This reserve essentially quantifies the cumulative impact of using LIFO on inventory valuation and, by extension, on retained earnings and deferred taxes.

LIFO liquidation occurs when a company sells more inventory than it purchases or produces in a given period, causing it to sell older, lower-cost inventory layers. In an inflationary environment, where older inventory costs are typically lower, dipping into these layers results in a lower Cost of Goods Sold than if current costs were used. This can inflate reported gross profits and net income in the period it occurs, potentially leading to a higher taxable income and increased tax payments, which is often an unintended consequence for companies that adopted LIFO for tax benefits. Companies generally aim to avoid LIFO liquidation, or at least manage it strategically, due to these potential adverse financial and tax consequences.