Who Uses LIFO and Why Do They Use It?

Last-In, First-Out (LIFO) is an inventory costing method operating on the assumption that the most recently acquired inventory items are the first ones to be sold. This accounting principle determines how the cost of goods sold and the value of remaining inventory are calculated. When a sale occurs, the cost assigned to that sale is based on the price of the newest stock, not the oldest.

As a result, the inventory remaining on a company’s balance sheet is valued at the oldest costs. This method does not reflect the actual physical flow of goods, as most businesses aim to sell their oldest stock first. LIFO is a costing assumption used for financial reporting and tax purposes.

Industries Commonly Using LIFO

The LIFO method is most prevalent in industries where inventory costs are consistently rising and the products are largely fungible, meaning individual units are interchangeable. Automobile dealerships are a prime example. New vehicles of the same model year are identical, but their invoice costs from the manufacturer can increase during the year, and using LIFO allows a dealer to match the cost of the most recently purchased cars against sales revenue.

The oil and gas industry also frequently uses LIFO. The cost to extract or purchase a barrel of oil fluctuates, but a barrel of crude oil is a uniform commodity. By using LIFO, an energy company can charge the most recent, and often higher, crude oil costs to its cost of goods sold.

Other sectors, including certain retail and pharmaceutical companies, also adopt LIFO. Retailers dealing in non-perishable goods with rising prices, like hardware or building supplies, may find it beneficial. The choice is strategic rather than universal within an industry, as some major retailers use LIFO while competitors use other methods.

The Primary Motivation for Adopting LIFO

The primary motivation for selecting LIFO is its impact on taxable income during periods of inflation. When prices are rising, LIFO matches the newest, most expensive inventory costs against current revenues. This results in a higher cost of goods sold (COGS) compared to other methods like First-In, First-Out (FIFO).

A higher COGS leads to lower reported gross profit and, consequently, lower net income. Since corporate income tax is calculated based on net income, a lower profit figure means a smaller tax liability. This tax deferral is the primary economic benefit of using LIFO, allowing a company to retain more cash in the short term that can be reinvested into the business.

Consider a simple example: a company buys one item for $10 and a second, identical item later for $15. It then sells one item for $25. Under LIFO, the COGS would be $15, resulting in a profit of $10. Under FIFO, the COGS would be $10, yielding a profit of $15. If the corporate tax rate is 21%, the LIFO company pays $2.10 in tax, while the FIFO company pays $3.15.

The cash saved from lower tax payments provides a tangible financial incentive for using LIFO when inventory costs are consistently increasing.

The LIFO Conformity Rule

A regulation governing the use of LIFO in the United States is the LIFO conformity rule. This rule mandates that if a company elects to use the LIFO method for federal income tax purposes, it must also use the LIFO method for its financial reporting to shareholders, creditors, and other external parties.

This requirement prevents a company from presenting two different versions of its financial performance. A business cannot use LIFO on its tax return to report lower income while using a method like FIFO on its financial statements to report higher income to investors. The rule enforces consistency between tax and financial accounting.

The conformity rule ensures that the tax benefits of LIFO come with a trade-off: lower reported earnings per share and net income in financial statements during inflationary times. This can impact stock prices and how investors perceive the company’s profitability.

International Financial Reporting Standards Prohibition

The use of LIFO is a U.S.-centric practice, as International Financial Reporting Standards (IFRS) prohibit its use. IFRS is the required accounting framework in most countries outside of the United States, creating a global divergence in inventory accounting. Companies that report under IFRS must use either the FIFO or weighted-average cost method for their inventory.

The reason for the IFRS ban is that LIFO can distort earnings and reduce the comparability of financial statements between companies. A concern is that LIFO leaves old, potentially obsolete costs on the balance sheet, which may not accurately reflect the current value of the inventory. This can misrepresent a company’s true financial position.

IFRS aims to provide financial statements that reflect current economic conditions. The use of LIFO can lead to a “LIFO liquidation,” where a company sells more inventory than it purchases, causing old, lower costs to be matched against current revenues. This can artificially inflate reported profits in a way that is not sustainable, a practice IFRS seeks to prevent.