What is Last-In First-Out (LIFO)?
Last-in First-out (LIFO) is an inventory valuation method based on the assumption that assets produced or acquired last are the first to be expensed. In other words, under the last-in, first-out method, the latest purchased or produced goods are removed and expensed first. Therefore, the old inventory costs remain on the balance sheet while the newest inventory costs are expensed first.
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Example of Last-In, First-Out (LIFO)
Company A reported beginning inventories of 200 units at $2/unit. Also, the company made purchases of:
- 125 units @ $3/unit
- 170 units @ $4/unit
- 300 units @ $5/unit
If the company sold 350 units, the order of cost expenses would be as follows:
300 units at $5/unit = $1,500 in COGS, as illustrated above. The cost of goods sold (COGS) is determined with the last purchased inventories and moves it upwards to beginning inventories until the required number of units sold is fulfilled. For the sale of 350 units:
- 50 units at $4/unit = $200 in COGS
The total cost of goods sold for the sale of 350 units would be $1,700.
The remaining unsold 450 would remain on the balance sheet as inventory for $1,275.
- 125 units at $4/unit = $500 in inventory
- 125 units at $3/unit = $375 in inventory
- 200 units at $2/unit = $400 in inventory
LIFO vs. FIFO
To reiterate, LIFO expenses the newest inventories first. In the following example, we will compare it to FIFO (first in first out). FIFO expenses the oldest costs first.
Consider the same example above. Recall that under LIFO, the cost flows for the sale of 350 units are as follows:
Compare it to the FIFO method of inventory valuation, which expenses the oldest inventories first:
Under FIFO, the sale of 350 units:
- 200 units at $2/unit = $400 in COGS
- 125 units at $3/unit = $375 in COGS
- 25 units at $4/unit = $100 in COGS
The company would report the cost of goods sold of $875 and inventory of $2,100.
- COGS = $1,700
- Inventory = $1,275
- COGS = $875
- Inventory = $2,100
Therefore, we can see that the financial statements for COGS and inventory depend on the inventory valuation method used. Using Last-In First-Out, there are more costs expensed. As discussed below, it creates several implications on a company’s financial statements.
Impact of LIFO Inventory Valuation Method on Financial Statements
Recall the comparison example of Last-In First-Out and another inventory valuation method, FIFO. The two methods yield different inventory and COGS. Now it is important to consider – what impact does the use of LIFO make on a company’s financial statements?
1. Low quality of balance sheet valuation
By using LIFO, the balance sheet shows lower quality information about inventory. It expenses the newest purchases first, leaving older, outdated costs on the balance sheet as inventory.
For example, consider a company with a beginning inventory of two snowmobiles at a unit cost of $50,000. The company purchases another snowmobile for a price of $75,000. For the sale of one snowmobile, the company will expense the cost of the newer snowmobile – $75,000.
Therefore, it will provide lower-quality information on the balance sheet compared to other inventory valuation methods as the cost of the older snowmobile is an outdated cost compared to current snowmobile costs.
2. High quality of income statement matching
Since LIFO expenses the newest costs, there is better matching on the income statement. The revenue from the sale of inventory is matched with the cost of the more recent inventory cost.
For example, consider a company with a beginning inventory of 100 calculators at a unit cost of $5. The company purchases another 100 units of calculators at a higher unit cost of $10 due to the scarcity of materials used to manufacture the calculators.
If the company made a sale of 50 units of calculators, under the LIFO method, the most recent calculator costs would be matched with the revenue generated from the sale. It would provide excellent matching of revenue and cost of goods sold on the income statement.
LIFO in Accounting Standards
Under IFRS and ASPE, the use of the last-in, first-out method is prohibited. However, under GAAP, the use of Last-In First-Out is permitted. The inventory valuation method is prohibited under IFRS and ASPE due to potential distortions on a company’s profitability and financial statements.
The revision of IAS Inventories in 2003 prohibited LIFO from being used to prepare and present financial statements. One of the reasons is that it can reduce the tax burden in the case of inflating prices. Recall the example we did above and assume that the sales price of a unit of inventory is $15:
- COGS = $1,700
- Revenue = 350 x $15 = $5,250
Gross profits under LIFO = $5,520 – $1,700 = $3,820
- COGS = $875
- Revenue = 350 x $15 = $5,250
Gross profits under FIFO = $5,520 – $875 = $4,645
Under LIFO, the company reported a lower gross profit even though the sales price was the same. Now, it may seem counterintuitive for a company to underreport profits. However, by using LIFO, the cost of goods sold is reported at a higher amount, resulting in a lower profit and thus a lower tax. Therefore, it can be used as a tool to save on tax expenses.
However, the main reason for discontinuing the use of LIFO under IFRS and ASPE is the use of outdated information on the balance sheet. Recall that with the LIFO method, there is a low quality of balance sheet valuation. Therefore, the balance sheet may contain outdated costs that are not relevant to users of financial statements.
Key Takeaways from Last-in First-Out (LIFO)
- Last-In First-Out expenses the newest costs first. In other words, the cost of goods purchased last (last-in) is first to be expensed (first-out).
- It provides low-quality balance sheet valuation.
- It provides high-quality income statement matching.
- LIFO is prohibited under IFRS and ASPE. However, under the US Generally Accepted Accounting Principles (GAAP), it is permitted.
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