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LIFO Method - AccountingTools http://www.accountingtools.com/lifo-method[3/29/2015 11:41:17 AM] CPE Books Financial Accounting Operational Accounting Podcast Q&A Dictionary About Home Search the Site 1,000+ Accounting Topics! Accounting Bestsellers Accountants' Guidebook Accounting Controls Accounting for Managers Accounting Procedures Bookkeeping Guidebook Budgeting Business Ratios Cash Management CFO Guidebook Closing the Books Controller Guidebook Corporate Finance Cost Accounting Cost Management Guidebook Credit & Collection Guidebook Financial Analysis Fixed Asset Accounting GAAP Guidebook Hospitality Accounting IFRS Guidebook Interpretation of Financials Inventory Accounting Investor Relations Lean Accounting Guidebook Mergers & Acquisitions Nonprofit Accounting Payables Management Payroll Management Public Company Accounting Operations Bestsellers Constraint Management Human Resources Guidebook Inventory Management Purchasing Guidebook Sign Up for Discounts Your E-Mail Address * Receive monthly discounts on accounting CPE courses & books Home >> Inventory Accounting Topics The Last-in, First-out Method | LIFO Inventory Method What is LIFO? The last in, first out (LIFO) method is used to place an accounting value on inventory. The LIFO method operates under the assumption that the last item of inventory purchased is the first one sold. Picture a store shelf where a clerk adds items from the front, and customers also take their selections from the front; the remaining items of inventory that are located further from the front of the shelf are rarely picked, and so remain on the shelf – that is a LIFO scenario. The trouble with the LIFO scenario is that it is rarely encountered in practice. If a company were to use the process flow embodied by LIFO, a significant part of its inventory would be very old, and likely obsolete. Nonetheless, a company does not actually have to experience the LIFO process flow in order to use the method to calculate its inventory valuation. Effects of LIFO Inventory Accounting The reason why companies use LIFO is the assumption that the cost of inventory increases over time, which is a reasonable assumption in times of inflating prices. If you were to use LIFO in such a situation, the cost of the most recently acquired inventory will always be higher than the cost of earlier purchases, so your ending inventory balance will be valued at earlier costs, while the most recent costs appear in the cost of goods sold. By shifting high- cost inventory into the cost of goods sold, a company can reduce its reported level of profitability, and thereby defer its recognition of income taxes. Since income tax deferral is the only justification for LIFO in most situations, it is banned under international financial reporting standards (though it is still allowed in the United States under the approval of the Internal Revenue Service). Example of the Last-in, First-out Method Milagro Corporation decides to use the LIFO method for the month of March. The following table shows the various purchasing transactions for the company’s Elite Roasters product. The quantity purchased on March 1 actually reflects the inventory beginning balance. Date Purchased Quantity Purchased Cost per Unit Units Sold Cost of Layer #1 Cost of Layer #2 Total Cost March 1 150 $210 95 (55 x $210) $11,550 March 7 100 235 110 (45 x $210) 9,450 March 11 200 250 180 (45 x $210) (20 x $250) 14,450 March 17 125 240 125 (45 x $210) (20 x $250) 14,450 March 25 80 260 120 (25 x $210) 5,250 The following bullet points describe the transactions noted in the preceding table: March 1. Milagro has a beginning inventory balance of 150 units, and sells 95 of these units between March 1 and March 7. This leaves one inventory layer of 55 units at a Operational Accounting Topics

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  • LIFO Method - AccountingTools

    http://www.accountingtools.com/lifo-method[3/29/2015 11:41:17 AM]

    C P E B o o k s F i n a n c i a l A c c o u n t i n g O p e r a t i o n a l A c c o u n t i n g P o d c a s t Q & A D i c t i o n a r y A b o u t H o m e

    Search the Site

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    Home >> Inventory Accounting Topics

    The Last-in, First-out Method | LIFO Inventory Method

    What is LIFO?

    The last in, first out (LIFO) method is used to place an accounting value on inventory. The

    LIFO method operates under the assumption that the last item of inventory purchased is

    the first one sold. Picture a store shelf where a clerk adds items from the front, and

    customers also take their selections from the front; the remaining items of inventory that

    are located further from the front of the shelf are rarely picked, and so remain on the shelf

    that is a LIFO scenario.

    The trouble with the LIFO scenario is that it is rarely encountered in practice. If a company

    were to use the process flow embodied by LIFO, a significant part of its inventory would be

    very old, and likely obsolete. Nonetheless, a company does not actually have to experience

    the LIFO process flow in order to use the method to calculate its inventory valuation.

    Effects of LIFO Inventory Accounting

    The reason why companies use LIFO is the assumption that the cost of inventory increases

    over time, which is a reasonable assumption in times of inflating prices. If you were to use

    LIFO in such a situation, the cost of the most recently acquired inventory will always be

    higher than the cost of earlier purchases, so your ending inventory balance will be valued at

    earlier costs, while the most recent costs appear in the cost of goods sold. By shifting high-

    cost inventory into the cost of goods sold, a company can reduce its reported level of

    profitability, and thereby defer its recognition of income taxes. Since income tax deferral is

    the only justification for LIFO in most situations, it is banned under international financial

    reporting standards (though it is still allowed in the United States under the approval of the

    Internal Revenue Service).

    Example of the Last-in, First-out Method

    Milagro Corporation decides to use the LIFO method for the month of March. The following

    table shows the various purchasing transactions for the companys Elite Roasters product.

    The quantity purchased on March 1 actually reflects the inventory beginning balance.

    Date

    Purchased

    Quantity

    Purchased

    Cost per

    Unit

    Units

    Sold

    Cost of

    Layer #1

    Cost of

    Layer #2

    Total

    Cost

    March 1 150 $210 95 (55 x $210) $11,550

    March 7 100 235 110 (45 x $210) 9,450

    March 11 200 250 180 (45 x $210) (20 x $250) 14,450

    March 17 125 240 125 (45 x $210) (20 x $250) 14,450

    March 25 80 260 120 (25 x $210) 5,250

    The following bullet points describe the transactions noted in the preceding table:

    March 1. Milagro has a beginning inventory balance of 150 units, and sells 95 of these

    units between March 1 and March 7. This leaves one inventory layer of 55 units at a

    O p e r a t i o n a l A c c o u n t i n g T o p i c s

  • LIFO Method - AccountingTools

    http://www.accountingtools.com/lifo-method[3/29/2015 11:41:17 AM]

    cost of $210 each.

    March 7. Milagro buys 100 additional units on March 7, and sells 110 units between

    March 7 and March 11. Under LIFO, we assume that the latest purchase was sold first,

    so there is still just one inventory layer, which has now been reduced to 45 units.

    March 11. Milagro buys 200 additional units on March 11, and sells 180 units between

    March 11 and March 17, which creates a new inventory layer that is comprised of 20

    units at a cost of $250. This new layer appears in the table in the Cost of Layer #2

    column.

    March 17. Milagro buys 125 additional units on March 17, and sells 125 units between

    March 17 and March 25, so there is no change in the inventory layers.

    March 25. Milagro buys 80 additional units on March 25, and sells 120 units between

    March 25 and the end of the month. Sales exceed purchases during this period, so the

    second inventory layer is eliminated, as well as part of the first layer. The result is an

    ending inventory balance of $5,250, which is derived from 25 units of ending inventory,

    multiplied by the $210 cost in the first layer that existed at the beginning of the month.

    Related Topics

    FIFO vs. LIFO accounting

    First-in first-out method

    Specific identification method

    Weighted average method

    What are perpetual LIFO and periodic LIFO?

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