Last-In-First-Out (LIFO) Cost

Definition

Last-In-First-Out (LIFO) Cost is a method of inventory valuation whereby the most recently produced or acquired items are considered the first to be sold or used. In other words, under LIFO costing, the cost of the most recent stock purchases or productions is applied to the cost of goods sold before earlier purchases or productions.

Key Points:

Recent Costs Applied First: The latest costs incurred are applied first to calculate cost of goods sold (COGS).
Impact on Financial Statements: LIFO can lead to lower reported profits during periods of rising prices due to higher COGS, which may result in lower taxes.
Inventory Valuation: Ending inventory is valued at older prices, which might be significantly different from current market prices.
Acceptance: This method is widely accepted in the U.S. under Generally Accepted Accounting Principles (GAAP) but not allowed under International Financial Reporting Standards (IFRS).

Examples

Example 1: Raw Materials Inventory

A company purchases 100 units of raw material at $5/unit on January 1, 2023. Then, it purchases another 100 units at $6/unit on February 1, 2023. If the company issues 70 units on March 1, 2023, under LIFO, the units issued would be priced at $6, leading to an issuance cost of $420.

Example 2: Finished Goods Inventory

A manufacturing company finishes 200 units of its product in January at a cost of $10/unit. In February, it finishes another 300 units at a cost of $12/unit. If the company sells 250 units in March, it will price the first 250 units sold at $12/unit amounting to a cost of $3,000 under LIFO.

Frequently Asked Questions (FAQs)

1. Why do companies use LIFO?

Companies use LIFO to match current revenue with current costs, which can minimize taxable income during periods of inflation.

2. What are the disadvantages of using LIFO?

LIFO can distort inventory valuation and doesn’t reflect actual physical inventory flow. During periods of deflation, it can also result in higher taxable income.

3. Is LIFO allowed under IFRS?

No, LIFO is not permitted under International Financial Reporting Standards (IFRS). It is, however, accepted under U.S. GAAP.

4. How does LIFO affect financial statements?

LIFO usually results in higher COGS and lower ending inventory values, leading to lower taxable income and net profit in times of rising prices.

5. Can a company switch from FIFO to LIFO?

Yes, companies can switch from FIFO to LIFO, but it may require regulatory approval and can involve complex adjustments to financial records.

6. What is the tax benefit of using LIFO?

By increasing COGS during periods of inflation, LIFO can reduce taxable income and defer tax liability.

7. How does LIFO affect gross profit?

LIFO often results in lower gross profit compared to FIFO in periods of rising prices since the newest, higher costs are used first.

8. What is LIFO liquidation?

LIFO liquidation occurs when older inventory costs are charged to COGS, typically as a result of inventory reductions, which can increase taxable income if older costs are lower.

First-In-First-Out (FIFO) Cost

FIFO is an inventory valuation method where the oldest stocks are considered sold first. This method can provide a more accurate reflection of the inventory flow and typically results in lower COGS during inflationary periods compared to LIFO.

Process Costing

A costing method used to value the work in process at the end of an accounting period by spreading total production costs across all units produced. It contrasts with job-order costing.

Next-In-First-Out (NIFO) Cost

A theoretical inventory valuation method using next purchase costs or future costs rather than actual historical cost layers. It’s not commonly used in practice.

Online Resources

Suggested Books for Further Studies

“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
“Accounting Made Simple: Accounting Explained in 100 Pages or Less” by Mike Piper
“Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav Rajan
“Financial Accounting: An Introduction to Concepts, Methods and Uses” by Clyde P. Stickney and Roman L. Weil

Accounting Basics: Last-In-First-Out (LIFO) Fundamentals Quiz

### What does LIFO stand for? - [ ] Last-In-First-Out - [x] Last-In-First-Only - [ ] Last-In-Feedback-Out - [ ] Last-In-First-Override > **Explanation:** LIFO stands for "Last-In-First-Out," a method that assumes that the most recently acquired inventory items are the first to be sold or used. ### In LIFO costing, which inventory units are considered first when calculating Cost of Goods Sold (COGS)? - [x] The most recently purchased or produced units - [ ] The oldest purchased or produced units - [ ] A mix of old and new units - [ ] Future purchase units > **Explanation:** LIFO costing values the most recently purchased or produced units first when calculating COGS. ### Why might a company choose to use LIFO costing? - [x] To minimize taxable income during inflation - [ ] To increase the apparent profitability - [ ] To match older costs with current revenues - [ ] To streamline inventory valuations under IFRS > **Explanation:** Companies may use LIFO to minimize taxable income during periods of rising prices because it results in higher COGS and lower taxable income. ### Is LIFO permitted under International Financial Reporting Standards (IFRS)? - [x] No - [ ] Yes - [ ] Only in specific countries - [ ] It depends on the industry > **Explanation:** LIFO is not permitted under IFRS, it's only accepted under U.S. GAAP. ### How does LIFO affect reported earnings in periods of rising prices compared to FIFO? - [x] It results in lower reported earnings - [ ] It results in higher reported earnings - [ ] No impact - [ ] It results in fluctuating earnings > **Explanation:** During periods of rising prices, LIFO results in lower reported earnings due to higher COGS. ### Under LIFO, what happens to the ending inventory valuation? - [ ] It is based on the most recent cost prices - [ ] It remains constant throughout the year - [x] It is based on older cost prices - [ ] It matches current market prices > **Explanation:** The ending inventory is valued at older prices under LIFO, which may not reflect current market prices. ### During inflation, how does the use of LIFO affect the company's tax liability? - [x] Decreases tax liability - [ ] Increases tax liability - [ ] No impact - [ ] Slightly increases tax liability > **Explanation:** LIFO decreases tax liability during inflation by showing higher COGS and lower taxable income. ### Can a company using LIFO see an increase in taxable income if it reduces its inventory levels? - [x] Yes, it is referred to as LIFO liquidation - [ ] No, inventory levels do not affect the taxable income - [ ] Only if the inventory reduction is less than 10% - [ ] Yes, but only in specific scenarios > **Explanation:** LIFO liquidation occurs when a company reduces inventory levels significantly, using older, lower-cost inventory for COGS and thus increasing taxable income. ### What would be the effect on financial statements if a company switches from LIFO to FIFO? - [x] COGS could decrease, and net income could increase during inflation - [ ] COGS could increase, and net income could decrease during inflation - [ ] No significant impact - [ ] Increase in tax liability instantly > **Explanation:** Switching from LIFO to FIFO during inflation usually results in lower COGS and higher net income. ### How often do companies reassess the inventory costs under LIFO? - [x] Periodically, often annually or quarterly - [ ] Daily - [ ] According to real-time market conditions - [ ] Only at the accounting year end > **Explanation:** Companies typically reassess inventory costs periodically, such as annually or quarterly, under the LIFO method.

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