LIFO Cost Flow Assumption Method – How Does it Work?

what is LIFO inventory valuation method

In the previous post we explained one specific method for cost flow assumption called “first in, first out” or simply FIFO. In the same article we also touched on another method called LIFO. It’s time to explain what it is.

LIFO stands for “last in, first out” and it differs from FIFO in that it expenses the most recent (latest) cost of items bought as the cost of sold goods. What this basically means is that the oldest cost of goods are in turn reported as inventory.

For example, the company buys three air conditioners. One for $200, another for $250 and the last one for $300. Under LIFO, the company will ship the item bought for $200. However itt it can report the cost of sold item as $300 (under FIFO it would be $200). This will be the first cost the company reports. The inventory will report the older ones of $200 and $250.

What are the Uses for LIFO?

LIFO is a very popular method, particularly in times of price inflation. That’s because it works under the assumption that the inventory cost gets bigger over time. In that case, the cost of the newest purchase is always higher than the ones before it. This means that the cost of goods sold will be shown as the most recent cost, while the final inventory balance will be calculated at the earlier cost.

For a company, LIFO allows it to report a lower profitability and postpone its recognition of income taxes. This leads us to probably the biggest issue with LIFO. As it is only allowed for income tax deferral, LIFO is banned under the International Financial Reporting Standards (IFRS), but it is still in use in the US. However, you need to get the International Revenue Service (IRS) approval. Otherwise, companies might use it for tax evasion.

Another problem with last in, first out method is that such a scenario rarely happens in practice, only in theory. For instance, if a company is using LIFO, that likely means that a good portion of its inventory is old or even obsolete.

Conclusion

Despite its problems, LIFO is still a popular cost flow assumption method (although probably not as much as FIFO). I hope this post helped you better understand it. If you have any questions or comments, let me know in the comments below and don’t forget to sign up for a free Purchase Order Plus trial.

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