Last In, First Out (LIFO)
Last In, First Out (LIFO) is an inventory valuation method used in accounting that assumes the most recently produced or acquired items are the first to be used or sold. Under LIFO, the cost of goods sold (COGS) is based on the cost of the most recent inventory first. This accounting method can impact both the balance sheet and the income statement, particularly in periods of inflation, by matching current sales prices with current costs.
Examples
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Retail Store:
- A clothing retailer uses LIFO to value its inventory. The most recent shipment of winter jackets, acquired at $50 each, is sold first. Therefore, the cost of goods sold reflects the higher recent costs, which might lead to lower profits reported.
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Manufacturing Company:
- A manufacturing company produces gadgets with materials costing them differently throughout the year due to fluctuating prices. By using LIFO, they can match the most recent, possibly higher production costs with sales revenue, reducing taxable income during inflationary periods.
Frequently Asked Questions (FAQs)
Q1: Why would a company use LIFO instead of FIFO (First In, First Out)? A1: LIFO is often used during times of rising prices (inflation) because it matches the higher recent costs with revenue, thus reducing taxable income and liabilities.
Q2: Is LIFO allowed internationally? A2: No, LIFO is not permitted under International Financial Reporting Standards (IFRS). It is primarily used in the United States under Generally Accepted Accounting Principles (GAAP).
Q3: How does LIFO affect financial statements? A3: LIFO can reduce reported net income during inflationary periods because it increases the cost of goods sold. It may also impact the valuation of ending inventory on the balance sheet, typically showing lower ending inventory values.
Q4: What is a LIFO reserve? A4: The LIFO reserve is the difference between the inventory reported using LIFO and what the inventory would have been using FIFO. It is disclosed in the financial statements and indicates the potential tax impact if the company were to switch to FIFO.
Q5: Can a company switch from LIFO to FIFO? A5: Yes, a company can switch from LIFO to FIFO, but it must apply for approval from the IRS and the change must be applied consistently going forward.
Related Terms with Definitions
- First In, First Out (FIFO): An inventory valuation method where the oldest inventory items are recorded as sold first.
- Weighted Average Cost (WAC): An inventory valuation method that assigns an average cost to each unit of inventory when sold.
- Cost of Goods Sold (COGS): The direct costs of producing goods sold by a company.
- Inventory Turnover: A ratio showing how many times a company’s inventory is sold and replaced over a specific period.
Online References
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant Datar, and Madhav Rajan
- “Financial & Managerial Accounting” by Carl S. Warren, James M. Reeve, and Jonathan Duchac
Fundamentals of Last In, First Out (LIFO): Accounting Basics Quiz
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