Last-In First-Out (LIFO) Method

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What is the Last-In First-Out (LIFO) Method? Meaning.

The Last-In First-Out (LIFO) Method is an accounting and valuation technique for inventories of produced goods, raw materials, parts, components, or feed stocks in which the most recent units available are assumed to be sold, used or disposed of first. Contrary to the FIFO Method, LIFO assumes that an entity sells, uses or disposes of its newest inventory first.

Note that the newest units may or may not be used in a physical manner: LIFO costing may be used even though physical withdrawal is in a different order.

The term LIFO is also used in Logistics Management to refer to a situation in which the oldest inventory items are physically used first (picture).

Advantages of LIFO Method. Benefits

The LIFO method matches the most recently incurred costs against revenues, which means that the most recently incurred costs will be virtually identical to current replacement costs, providing a good match between current costs and current revenues. Using the LIFO method to evaluate and manage inventory can be tax advantageous.

LIFO is one method used to determine Cost of Goods Sold for a business.

LIFO Ending Inventory

However, on the balance sheet, LIFO inventory consists of the oldest costs, which will usually not approximate current replacement cost of inventory. For companies that have used the LIFO method for many years, the inventory value under LIFO may only amount to a small fraction of what it would cost to replace this inventory at today's prices.

LIFO in US GAAP and IAS/IFRS

Although this method will seldom correspond to the actual physical flow of goods, it is accepted under U.S. GAAP (ASC 330), as U.S. GAAP does not require conformity between the assumed cost flow and the physical flow of units.

However, under IAS/IFRS, the LIFO method is prohibited.

Comparing LIFO and FIFO Firms

As LIFO inventory is usually carried at amounts that are much lower than FIFO inventory amounts, it is very difficult to compare LIFO versus FIFO firms meaningfully. In order to remedy this difficulty, the Securities and Exchange Commission (SEC) adopted a disclosure policy that requires LIFO firms to disclose the dollar magnitude of the difference between LIFO and FIFO inventory costs. This disclosure is called the LIFO Reserve and needs to be reported at each balance sheet date.

Disadvantages. LIFO Liquidation

Although LIFO has the advantage that taxes can be deferred, a LIFO inventory system may lead to LIFO Liquidation, a situation where in the absence of new replacement inventory, or a deliberate search for artificially increased profits (Earnings Management), older inventory is increasingly sold (liquidated).

If prices have been rising, for example through inflation, this older inventory will have a relatively low cost, and its liquidation leads to the recognition of a higher, inflated net income and corresponding payment of higher taxes, thus reversing the deferred tax advantage that initially encouraged the adoption of a LIFO system.

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