What Is the LIFO Method and How Does It Work?

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The LIFO inventory accounting method is beneficial for businesses that have new inventory. If prices and inflation rise, calculating inventory costs at the highest prices reduces profits and taxable income.

 

What Is Last In, First Out (LIFO)?

LIFO stands for "last in, first out" in inventory accounting. Companies use this accounting method to expense inventory items that they have recently purchased or manufactured. On financial statements, companies use the accounting method to expense the most recent inventory as the cost of goods sold (COGS).

In the United States, LIFO is one of three generally accepted accounting principles (GAAP). The other two are the "first in, first out" (FIFO) method (in which companies sell their initial inventory first) and the average cost method (in which business owners average unit costs from beginning to closing inventory). LIFO inventory management typically reduces net income but is advantageous for tax purposes during periods of inflation or rising prices.

 

What Is the LIFO Method and How Does It Work?

LIFO is a commonly accepted accounting principle (GAAP) in the United States. It is a method of reporting that aids inventory valuation. However, the LIFO method is not permitted by International Financial Reporting Standards (IFRS) because it can distort financial statements.

When taxes rise, using LIFO reduces taxable income while increasing cash flows. When there is no inflation, income statements and cost flow cancel out, and the method of inventory costing does not matter. However, if inflation is high and large or small businesses have excess inventory, LIFO can result in lower net income taxes because COGS (cost of goods sold) is higher.

 

Example of the LIFO Method

LIFO is an accounting principle that can increase inventory values. As an example of LIFO, suppose the fictional FastSpeed Car Company has one hundred used cars in inventory to sell. Consider the following aspects of revenue generation, from inventory creation to sales:

Inventory: The first fifty cars produced by the company cost $10,000 each. The last fifty vehicles manufactured by the company cost $20,000 each. The last cars manufactured by the company should be the ones sold first under the LIFO inventory management method.

Inventory costs: In this example, FastSpeed Car Company sells a total of eighty cars. Because all vehicles have the same sales price, revenue is the same; however, the cost of the vehicles to the company is determined by the inventory method used. According to the LIFO method, the last inventory (the more expensive cars) should be the first to sell.

Sales: Using the LIFO method, the company sells fifty cars that cost $20,000 to make first, then thirty cars that cost $10,000 to make. The total inventory is worth $1.3 million (50 at $20,000 and 30 at $10,000). Paying a lower taxable income fee by selling ending inventory when inflation and prices are up can benefit the company's balance sheet using LIFO accounting. This is advantageous because it lowers the total cost of taxable income when reporting to the IRS.

 

LIFO vs. FIFO Accounting Methods

Both the LIFO (last in, first out) and FIFO (first in, first out) methods are used to value inventory, but there are a few key differences:

Price of goods sold: Using LIFO, each item sold by a company raises the cost of goods sold. Companies compute ending inventory based on the cost of the oldest inventory. The unit cost of the oldest inventory determines the COGS in the FIFO method. The company is less likely to lose money if older products expire.

Order of inventory: Companies that use the LIFO inventory method sell the most recently received inventory first. Companies use FIFO to sell the oldest inventory first.

Net income: Generally, LIFO reduces net income, whereas selling the oldest inventory first increases net income.

Taxes: In times of high inflation, the LIFO inventory method results in lower profits, which translates to lower taxes. This tax savings benefits businesses because, when selling a large number of products in inventory, the amount companies owe in taxes decreases as prices rise. The FIFO method increases net income, which can be beneficial, but it also means that the company must pay more in income taxes.

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