Last In – First Out (LIFO)
Last In – First Out (LIFO) is a method of inventory management and asset valuation, commonly used in accounting and financial reporting. LIFO operates on the principle that the most recent inventory items or assets acquired are the first ones to be sold, used, or liquidated. This means that the cost of the most recently purchased items is matched against revenue first, while older inventory costs are matched against revenue at a later stage. LIFO is the opposite of the First In – First Out (FIFO) method, where the oldest inventory items are sold or used first.
How Last In – First Out (LIFO) Works
When a company uses the LIFO method for inventory valuation, it assumes that the most recently acquired inventory items have higher costs due to inflation or other factors. As a result, when the company sells goods, it recognizes the cost of goods sold (COGS) based on the cost of the most recent purchases. The ending inventory value in the accounting records consists mainly of older, potentially lower-cost inventory items.
Example of Last In – First Out (LIFO)
Let’s consider a manufacturing company that uses LIFO for its inventory management. In January, the company purchases 100 units of a particular raw material at $10 per unit. In February, it purchases an additional 200 units of the same raw material at $12 per unit. In March, the company sells 150 units of the raw material. Under the LIFO method, the cost of goods sold (COGS) would be calculated based on the most recent purchases, which were made in February at $12 per unit. Thus, the COGS for the 150 units sold in March would be $12 * 150 = $1,800.
Application of Last In – First Out (LIFO)
LIFO is commonly used in the United States for tax purposes, as it allows companies to reduce their taxable income by using the higher costs of recently acquired inventory items. However, the use of LIFO for financial reporting purposes is not allowed under International Financial Reporting Standards (IFRS).
Advantages of Last In – First Out (LIFO)
- Tax Savings: LIFO can result in lower taxable income, leading to potential tax savings for companies, especially during periods of inflation.
- Matching Revenue and Expenses: LIFO may provide a better matching of current revenue with current expenses in times of rising costs.
Disadvantages of Last In – First Out (LIFO)
- Distorted Inventory Valuation: LIFO may not reflect the true economic value of inventory, especially if inventory costs are increasing.
- Complex Accounting: Implementing LIFO can be complex and may require additional record-keeping.
Last In – First Out (LIFO) is an inventory valuation method that assumes the most recently acquired inventory items are the first ones to be sold or used. Although LIFO can provide potential tax advantages during inflationary periods, it may not accurately represent the true value of inventory, and it is not allowed under International Financial Reporting Standards (IFRS) for financial reporting purposes. As with any inventory valuation method, companies must carefully consider the implications of using LIFO and choose the method that best aligns with their business needs and financial reporting requirements.
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