The last-in, first-out (LIFO) method of costing inventory assumes that the most recently purchased items are the first ones sold and the remaining inventory consist of the earliest items purchased. In other words, the goods are sold in the reverse order in which they are bought. Unlike FIFO, the LIFO method specifies that the cost of inventory on hand (ending inventory) is determined by working forward from the beginning inventory through purchases until sufficient units are obtained to cover the ending inventory. This is the opposite of the FIFO system.
Remember the FIFO assumes costs flow in the order in which they are incurred, while LIFO assumes that costs flow in the reverse order form that in which they are incurred.
Example 1
Under LIFO, the inventory at the end of the period is considered to be merchandise purchased in the first part of the period. What is the cost of the385 units oh hand?
Jan. 1 purchase 115 units @ $8 = $ 920
Mar. 10 purchase 145 units @ $7 = 1,015
June 6 purchase 125 units @ $10 = 1,250
385 units $3,185
Thus, ending inventory under the LIFO method would be valued at $3,185
Example 2
The cost of goods sold is determined (from Example 1 by subtracting the value of the ending inventory from the total value of the inventory available for sale ($7,475 - $3,185 = $4,290). This cost may also be
Oct. 1 245 units @ $12 = $2,940
July 5 135 units @ $10 = 1,350
Cost of goods sold 380 units $4,290
A disadvantage of the LIFO method is that it does not represent the actual physical movement of goods in the business, as most business do not move out their most recent purchases. Yet firms favor this method because it does match the most recent costs against current revenue, thereby keeping earnings from being greatly distorted by any fluctuating increases or decreases in prices. Yet it sometimes allows too much maneuvering by managers to change net income. For example, if prices are rising rapidly and a company wishes to pay less taxes (lower net income) for that year, management can buy large amounts of inventory near the end of that period. These higher inventory costs, because of rising prices, under LIFO immediately become an expense (cost of goods sold), and thus result in the financial statement may want to increase net income to garner favor with stockholders. This can be done by delaying any large purchase of high-cost inventory until the following period by keeping the purchases out of the Cost of Goods Sold section for the current year, and thus avoiding any decrease in net income.
In a rising price market, certain tax advantages are gained through LIFO because it yields a lower profit because of its higher cost of goods sold.
Example 3
Use Chart 1.
FIFO LIFO
Sales (assumed) $25,000 $25,000
Cost of Goods Sold:
Goods Available for sale $7,475 $7,475
Less: Ending Inventory 5,070 3,185
Cost of Goods Sold 2,405 4,290
Gross Profit $22,595 $20,710
As Example 3 shows, LIFO produces (in a rising market)
(1) a lower ending inventory,
(2) a higher cost of goods sold,
(3) a lower gross profit. FIFO will produce the opposite.
The IRS will permit companies to use LIFO for tax purposes only if they use LIFO for financial reporting purposes. Thus, if a business uses LIFO for tax purposes, it must also report inventory and income on the same valuation basis in its financial statements, but it is allowed to report an alternative amount in the notes to the financial statements. This is permitted because it affords true financial analysis in comparing, on a similar basis, one business with another. It should be noted that a business cannot change its inventory valuation method any time it chooses. Once a method has been adopted, the business should use the same procedure from one period to the next. If management feels a need to change, permission must be granted by the IRS. The business must then follow specific authoritative guides that detail how the changes should be treated on financial statements.
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