Below, we’ll explore what the LIFO method is, how it works, and when it’s the best option for certain companies.
What is LIFO?
LIFO (Last In, First Out) is an inventory accounting method where the most recently purchased items are assumed to be sold first.
This approach is used to determine how inventory costs are recorded in financial statements, particularly the cost of goods sold (COGS) and ending inventory. Under LIFO, newer and often higher costs are recognized first, while older, cheaper inventory remains on the balance sheet. As a result, LIFO can significantly impact reported profit and taxes, especially during periods of rising prices.
Understanding the Last In, First Out (LIFO) Method
The LIFO method is a common way of valuing a company’s inventory. It’s an accounting term that stands for “Last In, First Out”, with the understanding that the newest shipments of goods are the ones the company sells to customers first.
Thus, the items that remain unsold in inventory are the ones that were purchased the earliest. The price of these goods will determine the total value of inventory. On the other hand, the value of items sold becomes your cost of goods sold (COGS). This is a line item on the income statement, which gets subtracted from total revenue to determine the gross profit for the period.
Under the LIFO method, companies ensure customers are sold the newest goods from the latest shipments, giving them a competitive advantage when peers are still selling older inventory.
Keep in mind, LIFO is just one of the three methods companies can use to value their inventory. The other two methods include average cost inventory or “First In, First Out” (FIFO).
To better understand how the LIFO method compares to other inventory valuation approaches, the table below highlights the key differences in how each method works and impacts financial results.
This comparison highlights a key takeaway: LIFO is often chosen for its tax advantages during periods of rising prices, while FIFO and average cost provide different perspectives on inventory value and profitability depending on how goods are used and priced.
What is LIFO in Accounting?
In accounting, LIFO is a cost flow assumption used to assign inventory costs to the income statement and balance sheet.
It does not necessarily reflect the physical movement of goods but instead determines which costs are recognized first when calculating financial results. By matching recent purchase costs with current revenue, LIFO provides a specific view of profitability based on current price levels. This method is permitted under the U.S. GAAP but is not allowed under International Financial Reporting Standards (IFRS).
How the LIFO Method Works?
The LIFO method works by assigning the cost of the most recently purchased inventory to current sales.
When a company sells goods, it records the cost of its newest inventory as COGS, even if older items are still physically in stock. This creates a cost structure that reflects recent market prices rather than historical ones. In periods of inflation, this leads to higher COGS and lower reported profit, while older, lower-cost inventory remains on the balance sheet.
What is the Difference Between FIFO and LIFO?
The main difference between FIFO and LIFO lies in how inventory costs are assigned when goods are sold.
FIFO (First In, First Out) assumes that the oldest inventory is sold first, while LIFO assumes that the newest inventory is sold first. This difference directly affects key financial metrics such as cost of goods sold, net income, and inventory valuation. In inflationary environments, FIFO typically results in higher profits, while LIFO results in lower profits and lower tax obligations.
LIFO vs FIFO Comparison
LIFO and FIFO are the two most commonly used inventory valuation methods, and choosing between them can significantly impact a company’s financial results.
While both methods are acceptable under the U.S. GAAP, they differ in how they assign costs to inventory and cost of goods sold. This difference becomes especially important during periods of inflation, where rising prices can lead to noticeable changes in profit, taxes, and inventory valuation.
The table below highlights the key differences between LIFO and FIFO:
In general, LIFO is more beneficial for reducing taxable income during inflation, while FIFO provides a higher reported profit and a balance sheet that reflects more current inventory values.
When Should You Use the LIFO Method?
Each of the three inventory valuation methods we listed above is acceptable under generally accepted accounting principles (GAAP) in the United States. So, when is it best to use the LIFO method?
The general outcome of using the LIFO method is a lower inventory value on the balance sheet and a higher COGS on the income statement. This is based on the assumption that prices for goods steadily increase over time. So, the inventory you purchased previously will cost less than the same units of inventory purchased today.
If you’re selling the most recent shipments to customers before dipping into your older inventory, you will incur higher COGS, while the value of remaining inventory is lower given the cheaper purchase price pre-inflation.
Thus, the LIFO method can be a better option for companies with larger volumes of inventory. It allows them to benefit from a lower tax liability by decreasing their profits with a higher cost of goods sold.
Regardless of the method you select, in order to remain compliant with GAAP, you’ll need to remain consistent with the method to ensure accurate and transparent financial reporting.
Example of the LIFO Inventory Method
After learning the basics of the LIFO method for valuing inventory, let's explore this method in further detail with an example of how it looks in a real-world setting.
Context and Background
A growing clothing retailer purchases inventory throughout the year. The company uses the LIFO method for inventory to prioritize a lower tax liability and keep a light balance sheet.
To prepare for the back-to-school season and keep up with summer shopping demands, the company makes one large purchase during the second quarter. They have some older shipments still in stock. But, because they use the LIFO method, they will fulfill customer orders using the newest inventory first.
Inventory Details
Here is a breakdown of the current items that the retailer has in stock before its latest round of purchases:
- 140 shirts purchased at $12 each
- Total cost: $1,680
Then, the company receives a new shipment:
- 250 shirts at $14 each
- Total cost: $3,500
Calculating Inventory with the FIFO Method
Throughout the quarter, the company sells 200 shirts. Under the LIFO method, this means they sell the newer-received stock first. So, after considering the current period sales, there are still 50 shirts from the new shipment in stock. This is valued at:
50 * $14 = $700
Then, we need to add this value to the value of the older shipment of shirts that are still in stock. As we previously calculated, this inventory is valued at $1,680.
We combine these two values to determine the total value of ending inventory under the LIFO method:
$700 + $1,680 = $2,380
To sum it up, the company will report an inventory of $2,380 on the balance sheet, and this value will be used to calculate the company’s COGS for the income statement.
Pros and Cons of the LIFO Method
Each method of valuing inventory has advantages and drawbacks. It’s important to consider the potential impact of an inventory method on your company’s accounting and financial statements before selecting one.
To help you better understand if LIFO is the best option for your business, we’ll now walk through some of the pros and cons of this method.
Pros
- It matches the current costs to the current revenues, providing a more accurate reflection of profits
- Can lower taxable income in periods of high inflation, using the more recent, higher purchase costs to determine cost of goods sold
- Reflects the nature of sales in industries where newer items are more desirable to customers, such as fashion or technology
Cons
- A number of countries that abide by International Financial Reporting Standards (IFRS) do not permit the use of the LIFO method
- It can artificially deflate earnings on the income statement, which can potentially misrepresent the company’s financial position
- In deflationary periods, the LIFO method can have the opposite intended effect, producing higher profits and lower ending inventory
- It’s a more complex method than the average inventory method, requiring tedious attention to detail
Properly Value Your Inventory with Help from Experts
The LIFO method is a common choice for valuing inventory. The method provides favorable tax advantages, though it will result in a lower profit on the income statement. The LIFO method isn’t for everyone, and it’s not permitted in all countries, though it can produce a number of benefits in the right circumstances.
Each company needs to thoroughly assess each option before choosing LIFO, FIFO, or the average cost method. Companies have the power to choose between either three. However, they must be consistent with a method once it’s chosen to remain compliant with US accounting standards.
If you want expert guidance on which method to select and how to implement it, contact us at Bob’s Bookkeepers to speak with one of our experienced advisors today.
