What Is LIFO? Definition, Examples, and Impact on Inventory Accounting.

If you’re studying accounting or managing inventory for a business, you’ve probably encountered the term LIFO. But what is LIFO, and how does it affect your bottom line?

LIFO, or Last-In, First-Out, is an inventory valuation method used in accounting to determine the cost of goods sold (COGS) and ending inventory. Under LIFO, the most recently purchased inventory is the first to be used or sold.

This article breaks down:

• The definition of LIFO
• How LIFO works with real examples
• LIFO vs. FIFO vs. other methods
• Pros and cons of using LIFO
• LIFO’s impact on taxes, profit, and financial statements

What Does LIFO Stand For?

LIFO stands for Last-In, First-Out.

In accounting terms, it means:

• The newest inventory items are sold or used first
• The oldest inventory remains on the books as ending inventory

It’s one of the three main inventory valuation methods:

• LIFO (Last-In, First-Out)
• FIFO (First-In, First-Out)
• Weighted Average Cost

How LIFO Works (Example)

Scenario:

• A company buys 100 units of a product in January at $10 each
• In February, they buy another 100 units at $12 each
• They sell 100 units in March

Under LIFO:

• The February batch ($12 each) is counted as sold first
• COGS = 100 x $12 = $1,200
• Ending Inventory = 100 units (from January) x $10 = $1,000

Under FIFO:

• The January batch ($10 each) is counted as sold first
• COGS = 100 x $10 = $1,000
• Ending Inventory = 100 units x $12 = $1,200

Key takeaway: LIFO reports higher COGS during inflation, reducing taxable income.

Why Use LIFO? Benefits for Businesses

BenefitWhy It MattersTax SavingsHigher COGS = lower net income = lower taxesMatches Current Costs to SalesReflects recent prices in income statementInflation ProtectionHelps offset rising costs by reducing reported profits

Disadvantages of LIFO

DrawbackImpactNot Accepted GloballyBanned under IFRS (used only in the U.S.)Lower Net IncomeCan make business appear less profitableInventory UnderstatementOlder, low-cost inventory remains on balance sheetComplex RecordkeepingRequires detailed tracking of purchase layers

LIFO and GAAP vs. IFRS

• GAAP (U.S.): Allows LIFO for financial and tax reporting
• IFRS (International): Does not allow LIFO—only FIFO or Weighted Average

This means companies using LIFO must switch methods when reporting to international stakeholders or operating abroad.

LIFO vs. FIFO: Key Differences

FeatureLIFOFIFOInventory SoldNewest items firstOldest items firstCOGS During InflationHigherLowerNet IncomeLowerHigherEnding InventoryLower valueHigher valueTax BenefitYes, in inflationary timesLess tax advantage

LIFO Reserve: Bridging the Gap

Many businesses use LIFO for taxes and FIFO for internal reporting. The LIFO reserve is an accounting adjustment that shows the difference between the two methods.

Formula:

LIFO Reserve = FIFO Inventory – LIFO Inventory

It helps analysts and auditors compare companies using different methods.

When to Use LIFO

LIFO is best for:

• U.S.-based businesses operating under GAAP
• Companies with rising inventory costs (e.g., oil, metals, electronics)
• Businesses seeking to reduce taxable income

Avoid LIFO if:

• You’re reporting internationally
• You’re in a deflationary market
• You want higher profits shown to investors or banks

Conclusion

To recap, LIFO (Last-In, First-Out) is an inventory valuation method that assumes the most recent inventory is sold first. It’s commonly used in industries affected by inflation and is legal only under U.S. GAAP.

While LIFO can offer tax advantages, it also has downsides like lower net income and outdated inventory valuation. It’s important to evaluate your accounting goals and reporting requirements before choosing LIFO for your business.

FAQs

1. What does LIFO stand for?

LIFO stands for Last-In, First-Out, an accounting method for inventory.

2. Is LIFO allowed under IFRS?

No. LIFO is not allowed under IFRS. It is only permitted under U.S. GAAP.

3. When should a company use LIFO?

LIFO is beneficial in times of inflation, especially for U.S. companies looking to reduce taxable income.

4. What industries commonly use LIFO?

Industries like oil and gas, automotive, and manufacturing often use LIFO due to fluctuating material costs.

5. What is a LIFO reserve?

It’s the difference between inventory reported under FIFO and LIFO. It helps analysts adjust LIFO numbers to compare with FIFO-based companies.