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Home Valuation of Inventories Last In First Out Method (LIFO Method)
 
 

Last In First Out Method (LIFO Method):

Learning objectives of this article:

  1. Define and explain last in first out (LIFO) method.

  2. How periodic and perpetual inventory systems impact this inventory valuation method.

  3. What are advantages and disadvantages of LIFO method?


Definition and Explanation:

The last in first out (LIFO) method first matches against revenue the cost of the last goods purchased. It a periodic inventory system is used, then it would be assumed that the cost of the total quantity sold or issued during the month have come from the most recent purchases. The ending inventory would be priced by using the total units as a basis of computation and disregarding the exact dates involved.

Example:

Assume that a company had the following transactions in the first month of operations.

Date Purchases Sold or Issued Balance
March 2 2,000 @ $4.00   2,000 units
March 15 6,000 @ $4.40   8,000 units
March 19   4,000 units 4,000 units
March 30 2,000 @ $4.75   6,000 units

Periodic Inventory System:

Assume that the cost of the 4,000 units withdrawn on absorbed the 2,000 units purchased on March 30 and 2,000 units of the 6,000 units purchased on March 15. The inventory and related cost of goods sold would then be computed as shown below:

Date of Invoice No. Units Unit Cost Total Cost
March 2 2,000 $4.00 8,000
March 15 4,000 $4.40 17,600
 
 
Ending inventory 6,000   $25,600
 
 
Goods available for sale $43,900  
Deduct: Ending inventory 25,600  
   
 
    $18,300  
   
 

Perpetual Inventory System:

If a perpetual inventory record is kept in quantities and dollars, application of the last in first out method will result in different inventory and cost of goods sold amounts as shown below:

Date Purchases Sold or Issued   Balance  
March 2 (2,000 @ $4.00)  $8,000     (2,000 @ $4.00) $8,000
March 15 (6,000 @ $4.40)   $26,400     (2,000 @ $4.00)
(6,000 @ $4.40)
$34,400
March 19   (4,000 @ $4.40)

$17,600

(2,000 @ $4.00)
(2,000 @ $4.40)
$16,800
March 30 (2,000 @ $4.75)  $9,500     (2,000 @ $4.00)
(2,000 @ $4.40)
(2,000 @ $4.75)
26,300

The month-end periodic inventory computation presented above (inventory $25,600 and cost of goods sold $18,300) shows a different amount from the perpetual inventory computation (inventory $26,300 and cost of goods sold $17,600). This is because the periodic system matches the total withdrawals for the month with the total purchases for the month in applying the last in first out method. In contrast, the perpetual system matches each withdrawal with the immediately preceding purchases. In effect, the periodic computation assumed that the cost of the goods that were purchased on March 30 were included in the sale or issue on March 19.

Advantages of Last in First Out LIFO) Method:

One obvious advantage of LIFO approach is that in certain satiations the LIFO cost flow actually approximates the physical flow of the goods in and out of inventory. For example, in the case of a coal pile, the last coal in is the first coal out because it is on the top of the pile. The coal remover is not going to take the coal from the bottom of the top of the pile. The coal that is going to be taken first is the coal that was placed on the pile last. How ever the coal pile situation is one of the only a few situations where the actual physical flow corresponds to LIFO. Therefore most adherents of LIFO use other arguments for its widespread employment, as follows:

Matching:

In LIFO, the more recent costs are matched against current revenues to provide a better measure of current revenues. During periods of inflation, many challenge the quality of non-LIFO earnings, noting that by failing to match current costs against current revenues, transitory or "paper" profits ("inventory profits") are created. Inventory profits occur when the inventory costs matched against sales are less than the inventory replacement cost. The cost of goods sold therefore is understated and profit is overstated. Using LIFO (rather than a method such as FIFO), current costs are matched against revenues and inventory profits are thereby reduced.

Tax Benefits/Improved Cash Flow:

Tax benefits are the major reason why LIFO has become popular. As long as the price level increases and inventory inventory quantities do not decrease, a deferral of income tax occurs, because the items most recently purchased at the higher price level are matched against revenues.

Future Earnings Hedge:

With LIFO, a company's future reported earnings will not be affected substantially by future price declines. LIFO eliminates or substantially minimizes write-downs to market as a result of price decreases. Since the most recent inventory is sold first, there is not much ending inventory sitting around at high prices vulnerable to a price decline. In contrast, inventory costed under FIFO is more vulnerable to price decline, which can reduce net income substantially.

Disadvantages of Last In First Out Approach:

Despite its advantages, LIFO has the following drawbacks:

Many corporate managers view the lower profits reported under the LIFO method in inflationary times as a distinct disadvantage. They would rather have higher reported profits than lower taxes. Some fear that an accounting change to LIFO may be misunderstood by investors and that, as a result of the lower profits, the price of the company's stock will fall. In fact, though, there is some evidence to reduce this contention.

Inventory Understated:

LIFO may have a distorting effect on the company's balance sheet. The inventory valuation is normally outdated because the oldest costs remain in the inventory. This understatement makes the working capital position of the company appear worse than it really is. The magnitude and direction of this variation between the carrying amount of inventory and its current price depend on the degree and direction of the price changes and the amount of inventory turnover. The combined effect of rising product prices and avoidance of inventory liquidations increases the difference between the inventory carrying value at LIFO and current prices of that inventory, thereby magnifying the balance sheet distortion attributed to the use of last in first out method.

Physical Flow:

LIFO does not approximate the physical flow of the items except in peculiar situations (such as the coal pile). Originally LIFO could be used in certain circumstances. This situation have changes over the years to the point where physical flow characteristics no longer play an important role in determining whether LIFO may be employed.

Involuntary Liquidation/Poor Buying Habits:

If the base or layers of old costs are eliminated, strange results can occur because old, irrelevant  costs can be matched against current revenues. A distortion in reported income for a given period may result, as well as consequences that are detrimental from an income tax point of view.

Because of liquidation problem, LIFO may cause poor buying habits. A company may simply purchase more goods and match these goods against revenue to ensure that the old costs are not charged to expense. Furthermore, the possibility always exists with LIFO that a company will attempt to manipulate its net income at the end of the year simply by altering its pattern of purchases.

Why do Companies Reject Last In First Out Method? Summary of responses

Reasons to Reject LIFO Number % of Total*
No expected tax benefits    
   No required tax payment 34 16%
   Declining prices 31 15
   Rapid inventory turnover 30 14
   Immaterial inventory 26 12
   Miscellaneous tax related 38 17
 

  159 74%
Regulatory or other restrictions 26 12%
Excessive cost    
   High administrative costs 29 14%
   LIFO liquidation-related costs 12 6
 

  41 20%
Other adverse consequences    
   Lower reported earnings 18 8%
   Bad accounting 7 3
 

  25 11%
 

*Percentage totals more than 100% as some companies offered more than one explanation.

Relevant Articles:

Classification of Inventory

Difference between Perpetual and Periodic Inventory System
Basic Issues in Inventory Valuation
Average Cost Method
First In First Out (FIFO) Method
Last In First Out (LIFO) Method
LIFO Reserve
LIFO Liquidation
Basis for Selection of Inventory Method

 

 

 

 

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Financial Accounting Topics


  Introduction to Accounting
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  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Accounts of Non-profit Making Organizations
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  Capital Investment Analysis/Capital Budgeting
 
 

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