What is LIFO?

LIFO or Last-In-First-Out is an inventory costing method in which cost of goods sold is based on the cost of the most recent purchases. In this method, ending inventory is costed at the cost of the oldest units available.

The most notable aspects about Last-in-first-out method are as follows –

  1. COGS does not reflects the usual physical flow of merchandise.
  2. The ending inventory may be costed at amounts prevailing several years ago.

Arguments for LIFO

Proponents of this inventory system base their conceptual argument on the matching principle. They argue that gross margin should reflect the difference sales and revenues. This matching argument assumes that  a company’s management sets selling prices by adding a margin to current costs rather than to historical costs. And if this is the case, then this inventory costing system reflects the management’s thinking with respect to the nature of gross margin.

Another important thing to note is that , though this conceptual argument involves the notion of current COGS. Here current COGS refers to the cost of acquiring items identical in type and number to those sold to replenish the inventory immediately after a sale. This process is called as replacement cost inventory accounting.

So, while focusing on income statement matching, advocates of this concept downplay its impact on balance sheet inventory evaluation. Because base layer of inventory is valued forever in terms of price levels prevailing when LIFO is adopted.  In situations such as at the time of inflation, this inventory valuation system may be far below the current costs. This makes the inventory figure of dubious usefulness.

The amount of inventory shown in balance sheet are unrealistically low. So, it is important for the company to provide for LIFO reserve date in the notes to the financial statements. This helps the users to convert the inventory to a FIFO basis by adding last-in-first-out reserve to LIFO inventory amount.

Why not more LIFO(Last-in-first-out)?

Last-in-first-out inventory valuation method improves a company’s after tax flow. So why don’t all companies use it for all of their inventories?

Well, although a company as a whole may be going through inflation, it doesn’t mean that prices of all the items will be increasing in company’s inventory. Second, though this method will reduce taxable income, thus lower income tax payments but there also will be decrease in earnings per share. Though research says that stock market does not penalize a company whose earnings drop due to change to LIFO.