As a society, we use the last-in-first-out (LIFO) method almost everywhere.
Picture a bookstore where the most recent copies of a book are placed at the front of the shelves and the older copies are pushed to the back.
When a reader wants to buy the book, they take the one at the front of the shelf first, just like in LIFO where the most recent items are sold first.
From an ecommerce perspective, you can think of your inventory as a stack of pancakes.
The last pancake you put on the plate is the first one you will eat. This is like the LIFO method, where the most recent items added to the inventory are the first to be sold.
The LIFO method is a time-tested approach to inventory accounting. It can help you not only save money on taxes but get a more accurate picture of the true value of your inventory.
In this post, we’ll discuss:
- The benefits and downsides of using the LIFO method for inventory valuation
- How the LIFO method can reduce your taxable income (with examples)
- Why you might choose LIFO over other Inventory Cost Flow Assumptions (and what that term means)
This post gets a bit into the weeds, but we’ll do our best to make it as simple as possible.
Let’s dive in!
What is the LIFO method?
The LIFO method, which stands for last-in-first-out, is an inventory valuation method used by companies to determine the cost of goods sold and the value of their remaining inventory.
It is based on the assumption that the most recent items added to the inventory are the first to be sold, while the older items remain in the inventory.
This method is used in accounting to reflect the changes in the cost of goods sold in the financial statements and to minimize the tax liability for the company.
LIFO was first introduced in the 1930s so companies could accurately reflect the changing cost of goods sold in their financial statements.
Before LIFO, companies used the FIFO (First-In-First-Out) method, which assumed that the first items added to the inventory were the first to be sold.
LIFO was seen as a more accurate reflection of the real-world operations of businesses, especially during times of inflation when the cost of goods was increasing.
LIFO is one of three Inventory Cost Flow Assumptions (or inventory costing methods), along with FIFO (first-in-last-out) and AVCO (average cost).
It’s also part of Generally Accepted Accounting Principles (GAAP) in the United States.
What are Inventory Cost Flow Assumptions?
Inventory Cost Flow Assumptions are methods used to determine the cost of goods sold (COGS) and the value of inventory on hand at a given period.
They help companies figure out how much their products have been sold for, as well as what is left in inventory. This helps businesses accurately report their financial statements and minimize their tax liability.
Businesses often use an Inventory Cost Flow Table to calculate the total cost of goods sold and closing inventory.
What is an Inventory Cost Flow Table?
I know we’re throwing a lot of terms at you, but bear with us –– these are important.
An Inventory Cost Flow Table is used to calculate the total cost of goods sold (COGS) and closing inventory for a given period. It lists all purchases, sales, and other transactions that affect the value of inventory.
The table is organized into two columns: units purchased or produced and unit cost. The rows list each transaction affecting inventory during the period in question.
The total cost of goods sold is the sum of all purchases or production costs listed in the table, while the closing inventory is the sum of all units left unsold.
By using this table, businesses can accurately determine their COGS and value of inventory on hand. This helps them report accurate financial statements and manage their tax liability.
How does the LIFO method work?
The LIFO method works by assuming that the most recent inventory items are the first to be sold. This means that when calculating COGS, businesses will use the cost of the most recently purchased items.
For example, if a company bought 10 widgets for $100 each, they would use the most recent 10 widgets (purchased at $100) to calculate their cost of goods sold.
This means that if they had older inventory still in stock, it would not be included in their COGS calculation. This is beneficial for companies because it allows them to reduce their tax liability by not including historical costs in their COGS.
We’ll talk more about the specific benefits of LIFO vs other Inventory Cost Flow Assumptions a bit later in the post.
How does LIFO accounting impact inventory valuation?
As we discussed earlier, LIFO accounting assumes that the most recently produced items added to inventory are the first to be sold.
This means that when calculating COGS and closing inventory, businesses use the cost of the most recent items in their calculations. This can have an impact on their inventory valuation –– especially during times of inflation or rising prices.
When a product’s sales price is increasing, using the LIFO method means that companies will be accounting for higher costs in their COGS calculation and lower values in their closing inventory calculation.
This means that the value of inventory on their financial statements will be lower, resulting in a lower amount of taxes paid. This is one of the main benefits of using LIFO over other Inventory Cost Flow Assumptions.
What are some other benefits of using LIFO vs FIFO or AVCO?
There are several benefits to using the LIFO method for inventory valuation:
- The most recent item costs are used in the calculation, resulting in lower taxes paid
- It more accurately reflects current market values
- It’s easier to maintain and can help businesses save time and money with record keeping
Using FIFO or AVCO methods could result in businesses paying more taxes than necessary.
Additionally, these methods may not accurately reflect current market values, as the costs of goods purchased in the past may be lower than what is currently being charged.
This could lead to inaccurate inventory valuation and financial statements.
LIFO drawbacks and International Financial Reporting Standards (IFRS)
While there are many benefits to using LIFO, it can also have some drawbacks.
LIFO is not accepted in all countries, and may not be allowed when doing business with foreign entities.
Additionally, the International Financial Reporting Standards (IFRS) do not allow for the use of LIFO for inventory valuation.
This means that businesses operating in countries using IFRS must use AVCO or FIFO.
Some other potential drawbacks of LIFO include:
- It may not accurately reflect actual inventory costs (especially during seasons of falling costs)
- It can lead to lower values being reported on financial statements
- It may be difficult to implement and maintain
Overall, businesses should carefully consider the pros and cons of using LIFO before deciding whether or not it is appropriate for their needs.
A step-by-step explanation of how a company calculates inventory value with LIFO
Calculating the value of inventory using LIFO is a fairly straightforward process.
Let’s go over each step in detail to ensure you have a full understanding of how it works:
1. Determine the cost per unit for your most recently purchased goods
This is calculated by taking the total amount spent on goods and dividing it by the total quantity.
2. Determine the number of units on hand
This is calculated by taking the quantity of goods available at your store or warehouse and subtracting any items that have already been sold.
3. Calculate the value of your inventory using LIFO
This is done by multiplying the cost per unit by the number of units on hand. This figure is then used to report your inventory value on the balance sheet.
4. Calculate the cost of goods sold (COGS)
This is done by subtracting the inventory value from the total amount spent on goods. This number is then reported on the income statement.
5. Calculate the closing inventory
This is calculated by subtracting COGS from the total number of units on hand. This figure is then reported on the balance sheet as your closing inventory value.
By following these steps, you can easily calculate LIFO and get an accurate picture of your company’s financial position.
To really drive this process home, let’s look at how this would look using both FIFO and LIFO.
Comparison of LIFO and FIFO methods
As you may have guessed from the name, LIFO and FIFO are complete opposites of one another.
To contrast their differences and the impact on inventory valuation, let’s look at an Inventory Cost Flow Table of a hypothetical business.
We’ll then analyze the inventory using both FIFO and LIFO and study how they differ.
To keep things simple, let’s assume a business receives 20 units at $100/per unit first. Then, due to inflation, a month later receives 40 units at $125/per unit.
Inventory Cost Flow Table
Unit Cost: $100
Total Cost: $2000
Unit Cost: $125
Total Cost: $5,000
Under FIFO, the oldest items (in this case 20 units at a cost of $100 each) are assumed to be sold first.
This means that COGS is calculated using the oldest unit costs, and closing inventory is valued at the newest cost.
COGS: 20 units x $100 = $2,000
Closing Inventory: 40 units x $125 = $5,000
Under LIFO, it is the exact opposite. The newest items (in this case 40 units at a cost of $125 each) are assumed to be sold first, meaning COGS and closing inventory are valued using the most recent costs.
COGS: 40 units x $125 = $5,000
Closing Inventory: 20 units x $100 = $2,000
As you can see, the difference between using FIFO or LIFO clearly affects inventory valuation and your balance sheet, which will result in a lower tax burden.
Why would anyone use FIFO if LIFO results in lower taxes?
If LIFO is so great at reducing your tax burden, why would anyone ever want to use FIFO? This is a common question we should pause to address.
The answer is that there are still certain challenges when using LIFO –– it isn’t perfect for all businesses at all times.
For instance, it can be difficult to maintain and inaccurate when dealing with seasonal fluctuations in price (especially if costs are decreasing).
It also does not work well for businesses that need more accurate records due to their business structure or industry regulations.
Also, while LIFO can reduce taxes, it may not be the best option when considering other factors such as cash flow and profitability.
For example, a business may want to report a higher income figure in order to attract investors.
At the end of the day, every business should carefully consider its options and make an informed decision based on its unique needs.
How will LIFO affect other financial statements in my business?
Using LIFO will affect all financial statements to some degree.
First, it results in a lower cost of goods sold, which affects your income statement.
This means that your gross margin, net income, and other important calculations based on these figures will be affected by the method you choose for inventory valuation.
Second, it affects the balance sheet by causing your inventory value to be reported at a lower number.
Finally, it affects your cash flow statement when you purchase new inventory — because when items are coming in with higher costs, your cash outflows will increase accordingly.
It is important to remember that regardless of which method you choose, all financial statements need to be in balance.
Therefore, the effects of using LIFO or FIFO should always be considered when preparing financial statements.
FAQs about last-in-first-out (LIFO) inventory management
What are Generally Accepted Accounting Principles?
Generally Accepted Accounting Principles (GAAP) are a set of standards and guidelines for financial accounting in the United States that are used to prepare, present, and report financial statements for public and private companies, as well as not-for-profit organizations.
The GAAP provides a framework for consistent reporting and helps ensure that financial information is presented fairly and accurately, allowing users to make informed decisions.
LIFO is a method of inventory valuation that is in line with Generally Accepted Accounting Principles (GAAP) in the United States.
Under LIFO, the cost of the most recently acquired inventory is recognized first when calculating the cost of goods sold (COGS) and, as a result, the ending inventory is valued using the cost of the oldest items in stock.
Ultimately, LIFO is considered a valid method of accounting under GAAP as long as it is consistently applied and clearly disclosed in financial statements.
What is beginning inventory balance?
The beginning inventory balance refers to the value of a company’s inventory at the start of a reporting period, typically a fiscal quarter or year.
This amount represents the value of the goods that the company has on hand and is typically shown as an asset on the company’s balance sheet.
The beginning inventory balance is important as it is used to calculate the cost of goods sold, which is a key component in determining the company’s overall profitability for the reporting period.
What is ending inventory?
Ending inventory is another critical term business owners must understand when discussing Inventory Cost Flow Assumptions.
Ending inventory refers to the value of unsold goods that a business still has on hand at the end of an accounting period. This value is typically reported on the balance sheet as a current asset.
The ending inventory value is important for determining a company’s cost of goods sold (COGS), which is subtracted from the company’s revenue to calculate its gross profit.
The accuracy of the ending inventory value can have a significant impact on a company’s financial statements, so it is important for businesses to maintain accurate records of their ending inventory balance and costs.
What is LIFO reserve?
LIFO reserve refers to the difference between the value of the inventory reported on a company’s balance sheet and the value that would have been reported if the company had used a different method of inventory valuation, such as FIFO.
In other words, it represents the adjustment made to the value of inventory as a result of using LIFO instead of another method. The LIFO reserve is a liability on the balance sheet and represents the additional tax liability that a company would incur if it were to sell its entire inventory.
In this article, we’ve looked at the differences between FIFO and LIFO inventory valuation methods.
We saw that while LIFO can reduce taxes, it may not be the best option when considering other factors such as cash flow and profitability.
Moreover, using either method affects all of your financial statements to some degree by impacting gross margin, net income, inventory value, and more.
Ultimately, businesses should take into account their own unique needs before deciding which approach is right for them.
As a general rule, if you’re looking to increase income on your financial statements and have more stable inventory costs, the FIFO method may be the better choice.
On the other hand, if you’re looking to reduce taxes at the cost of potentially fluctuating inventory costs, LIFO may be the right fit.
Good luck, and thanks for reading!