Definition§
Last In, First Out (LIFO) is an inventory valuation method whereby the most recently purchased or produced items are considered the first to be sold when calculating cost of goods sold (COGS). This accounting technique assumes that the latest inventory acquisitions are the first to go, potentially reducing taxable income during periods of rising prices by matching recent higher costs against current revenues.
Examples§
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Retail Store Example: A clothing retailer that adopts LIFO assumes they sell the latest received merchandise first. If the prices of clothes are increasing, the most expensive inventory is sold first, leading to higher COGS and lower reported income.
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Manufacturing Example: A car manufacturer using LIFO assumes that the cars most recently assembled are sold before older models. Hence, the cost of the most recent production batches is used for COGS calculations.
Frequently Asked Questions (FAQs)§
How does LIFO impact financial statements?§
LIFO often results in lower ending inventory values and higher COGS, resulting in lower taxable income and greater tax savings in periods of inflation.
Why might a business choose LIFO?§
Businesses may choose LIFO to reduce taxable income in times of increasing prices, leading to tax deferrals. It also matches recent costs with current revenues, providing a better reflection of current profit margins.
Is LIFO allowed under all accounting standards?§
No, LIFO is not permitted under International Financial Reporting Standards (IFRS). However, it is permissible under the Generally Accepted Accounting Principles (GAAP) in the United States.
How does LIFO affect financial ratios?§
Using LIFO can result in lower inventory levels and higher COGS, impacting various financial ratios. For instance, higher COGS may result in lower profitability ratios, and lower ending inventory values might affect working capital ratios.
Related Terms§
- First In, First Out (FIFO): An inventory valuation method where the oldest inventory items are considered sold first.
- Cost of Goods Sold (COGS): Direct costs attributable to the production of the goods sold by a company.
- Generally Accepted Accounting Principles (GAAP): A common set of accounting principles, standards, and procedures defined by the professional accounting industry.
- International Financial Reporting Standards (IFRS): Global accounting standards set by the International Accounting Standards Board (IASB).
Online References§
- Investopedia - Last In, First Out (LIFO)
- AccountingTools - LIFO Method: Accountants’ Daily Reference Guide
Suggested Books for Further Studies§
- “Financial Accounting” by Robert Libby, Patricia Libby, and Frank Hodge.
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield.
- “Advanced Accounting” by Debra C. Jeter and Paul K. Chaney.
Fundamentals of Last In, First Out (LIFO): Accounting Basics Quiz§
Thank you for exploring the intricacies of Last In, First Out (LIFO) with us, including tackling these comprehensive quiz questions to solidify your understanding!
