Inventories are no doubt one of the most important topics to understand in financial statements. It is a main account on the balance sheet for any companies that are selling goods. Inventories also indirectly touch the income statement via the cost of goods sold.
There are many ways to value inventories and one of them is the “last in, first out” method or more commonly referred to as the “LIFO” method. A dive into the LIFO method along with an example will help understand this topic.
LIFO Defined and Explained
LIFO is short for Last In, First Out and is one method used by companies to value their inventories. The concept is simple and is exactly as the name defines it; the last purchased or produced item will be the first one sold to a customer.
Using this logic, the cost of the last item purchased or produced will be included in the cost of goods sold on the income statement to determine profit whereas the first (or oldest) purchased or produced items remain in inventory and their cost will determine the balance of the inventory account on the balance sheet.
The LIFO method has limitations. Cost of goods tend to go higher over time (due to inflation for example) which means that using the LIFO method will increase the cost of goods sold included on the income statement since a company will take the higher cost of the latest item produced or purchased instead of the lower cost of the oldest items.
This will ultimately bring the net profit to a lower amount and in turn decrease the company’s income taxes. The amount sitting in inventory will also be understated compared to its true value.
Because of how easy it would be for management to manipulate net income and taxable amounts; the LIFO method is prohibited under IFRS. However, companies adopting US GAAP are allowed to use LIFO.
Other Methods of Inventory Valuation
The other two methods of valuing inventory are the First In, First Out (FIFO) and the Average Cost.
FIFO is a popular method used across industries and accepted by both US GAAP and IFRS. This is because FIFO tends to reflect a better image of inventories. Under FIFO, the first (or oldest) purchased or produced items will be the first items sold to customers.
The inventory balance with the FIFO method will reflect a better picture but in turn, it tends to decrease the actual cost of goods sold on the income statement, which increases net profit.
The Average Cost method will take the average cost of all items produced or purchased in order to determine inventory.
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LIFO Example
Let’s break it down and look at Carl’s Construction Company (“CCC”). CCC sells tiles and has 1,000 tiles in inventory. The 1,000 tiles are broken down as follows:
- 500 tiles were received by CCC about a month ago, on 1 December for a cost of $10 each.
- 300 tiles were received by CCC about two weeks ago, on 16 December for a cost of $15 each.
- The last 200 tiles were received by CCC a week ago, on 24 December for a cost of $17 each.
A customer decided to buy 600 tiles on 30 December so how much will be recorded as cost and how much will remain in inventory on 31 December?
Using the LIFO logic explained above, CCC is selling the latest received tiles first. In order, the 200 tiles received on 24 December are sold first, then comes the 300 tiles received on 16 December and lastly, another 100 tiles received on 1 December to complete the 600 tiles ordered by the customer.
The total cost is illustrated as follows:
| Tiles sold | Cost |
| 200 tiles received on 24 December for $17 each | $3,400 |
| 300 tiles received on 16 December for $15 each | $4,500 |
| 100 tiles received on 1 December for $10 each | $1,000 |
| $8,900 |
A total of $8,900 will be recorded as cost of goods sold on the income statement for the 600 tiles sold.
We know that following this sale, there are 400 tiles left in inventory, which are composed of the first tiles received by CCC, on 1 December. Those tiles cost $10 each, which means a total of $4,000 remains in inventory on the balance sheet at 31 December.
LIFO: Final Thoughts and Recap
The LIFO method consists of taking the last items produced or purchased as the first sold to a customer. In the income statement, the cost of the latest items in the inventory sold are included in the cost of goods sold.
That leaves the oldest items purchased or produced sitting in inventory and used to determine ending inventory at period end. LIFO can ultimately understate inventory and net income so for those reasons, this method is not acceptable under IFRS and is only accepted under US GAAP.
Other methods for valuing inventory and cost of goods sold are the FIFO and average cost methods.
