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What is Last In, First Out (LIFO)?
Last In, First Out (LIFO) is an inventory valuation method in accounting where the most recently acquired items are assumed to be sold first. It is used primarily in financial reporting and taxation to determine cost of goods sold (COGS) and inventory value.
Definition
LIFO is an inventory accounting method that assumes the newest inventory items are sold before older stock.
Key Takeaways
- Assumes the latest inventory is sold first.
- Often increases COGS during inflation, reducing taxable income.
- Not permitted under IFRS but allowed under U.S. GAAP.
Understanding LIFO
LIFO is commonly used in industries where inventory costs fluctuate significantly due to inflation or supply chain changes. Because it assumes recent (and often higher) costs are sold first, LIFO results in higher COGS and lower taxable income during inflationary periods.
However, LIFO does not reflect the actual physical flow of most goods. Many businesses prefer FIFO for operational accuracy, but LIFO remains a strategic choice for U.S.-based companies seeking tax advantages.
International firms operating under IFRS cannot use LIFO, making it less common globally.
Formula (If Applicable)
While LIFO does not have a single formula, it affects two major accounting calculations:
- COGS (LIFO) = Cost of most recent inventory purchases × Units sold
- Ending Inventory (LIFO) = Value of oldest remaining inventory
Real-World Example
A retailer buys inventory three times:
- Batch 1: 100 units @ $10
- Batch 2: 100 units @ $12
- Batch 3: 100 units @ $14
If the retailer sells 100 units using LIFO, the cost assigned to COGS is from Batch 3 ($14), even if the physical goods sold came from older stock.
During periods of inflation, companies like oil and manufacturing firms often use LIFO to reduce taxable income.
Importance in Business or Economics
LIFO matters because it:
- Reduces taxable income during inflation.
- Provides a conservative measure of profits due to higher COGS.
- Affects key financial metrics, including net income, gross margin, and inventory valuation.
- Creates comparability challenges across global firms due to IFRS restrictions.
Types or Variations (If Relevant)
- LIFO Perpetual System: COGS updated after every purchase.
- LIFO Periodic System: COGS calculated at the end of the accounting period.
- LIFO Reserve: Difference between LIFO and FIFO inventory values.
Related Terms
- FIFO (First In, First Out)
- Weighted Average Cost
- Inventory Valuation
Sources and Further Reading
- Financial Accounting Standards Board (FASB): https://www.fasb.org/
- Investopedia – LIFO: https://www.investopedia.com/terms/l/lifo.asp
- Corporate Finance Institute – LIFO Method: https://corporatefinanceinstitute.com/
Quick Reference
- Assumption: Newest inventory sold first.
- Effect: Higher COGS, lower taxable income during inflation.
- Not IFRS-Compliant: Only allowed under U.S. GAAP.
Frequently Asked Questions (FAQs)
Why do companies use LIFO?
To reduce taxable income during inflation by using higher recent costs in COGS.
Is LIFO used globally?
No, IFRS prohibits LIFO, making it primarily a U.S. accounting method.
Does LIFO reflect physical inventory flow?
Rarely. It is a cost-flow assumption used for financial reporting.
