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The Last in First Out (LIFO)
Cost Flow Assumption

Last in first out, or LIFO, is based on the assumption that the last good purchased are the first goods sold.




LIFO is a common method for assigning cost to inventory. The three other cost flow assumptions are FIFO, average cost, and specific identification. FIFO, or first in first out, assumes that the first goods purchased are the first goods used or sold.

Why Use Cost Flow Assumptions?

Companies can use cost flow assumptions regardless of the actual physical flow of inventory.

Inventory is recorded at historical cost, and then subject to an adjustment to the lower of cost or market (LCM).

But inventory items are purchased at different times during the year subject to different price fluctuations. Some companies, like Costco, Wal-Mart, and Home Depot, hold millions of inventory items at year-end. Imagine cases of ball point pens or nails coming into the retailer during the year at different times and subject to different price fluctuations.

For these companies with large inventories, tracing the original cost to every inventory item is neither cost-effective nor efficient, and one of the aims of GAAP is to present financial information only when the benefit of reporting that information exceeds the costs of obtaining it.

Though companies may track and measure each item internally for quality assurance and safety measures, it is not necessary to track the actual physical flow of inventory for financial reporting purposes.

Instead, cost flow assumptions are used to simplify inventory reporting and cost of goods sold. These cost flow assumptions simplify cost of goods sold and inventory accounting by reducing information required to a few data points in the cost flow process, such as beginning inventory, purchases, and ending inventory. Items can then be identified based on a cost flow assumption, as opposed to tracking the actual cost of every inventory item that are quickly buried and obscured in the physical flow of inventory.

Four Main Cost Flow Assumptions

The four main inventory cost flow assumptions are FIFO, LIFO, Average Cost, and Specific Identification.


LIFO: Lower Taxes for Rising Prices
LIFO comes from the US Internal Revenue Code
  • The IRS allows companies to apply LIFO to Inventory Items and Cost of Goods Sold for income tax reporting.

  • In periods of rising prices, the last and more expensive items purchased would be recorded into cost of goods sold, resulting in lower taxable income for tax reporting.

  • When a company chooses to use LIFO for tax purposes, it must use LIFO on its annual statements, and it must disclose what inventory would have been under FIFO.


Specific Identification Illustrated

The actual physical flow of inventory items which Sunny purchased over the past three months are as follows:

Actual Physical Flow of Inventory

Sunglasses Purchased two months ago:Sunglasses Purchased one month ago: Sunglasses purchased this week:
240 Sunglasses @$14 each:240 Sunglasses @$15 each:240 Sunglasses @$16 each:
$3,360
-
-
-
$3,600
-
-
-
$3,840


One sunlit summer afternoon, Sunny sells twenty five pairs of sunglasses. Unbeknownst to Sunny, the first twelve sunglasses came from Box 1 at $14 each, the next ten sold came from Box #2 at $15 each, and the last three pairs came from Box #3 at $16 each. If Sunny tracked every pair of sunglasses coming in, he would total his cost of goods sold based on the actual physical flow of inventory:

Inventory Accounting and COGS Using Specific Identification of Inventory
Sunglasses Purchased two months ago:Sunglasses Purchased one month ago: Sunglasses purchased this week:
12 @ $14:
10 @ $15:
3 @ $16:
$168
$150
$48
Total COGS: $366


Sunglasses Purchased two months ago:Sunglasses Purchased one month ago:Sunglasses purchased this week:
228 @ $14:
230 @ $15:
237 @ $16:
$3,192
$3,450
$3,792
Ending Inventory: $10,434


Last in First Out Illustrated

Alternatively, Sunny can calculate cost of goods sold and Ending Inventory based on the cost flow assumption that the last goods ordered are the first ones sold. Since the last items ordered last week cost $16 a pair, and the amount sold was 25 pairs of sunglasses, all of the pairs sold are applied to cost of goods sold at $16 per pair, the last box ordered:

Sunglasses Purchased two months ago:Sunglasses Purchased one month ago: Sunglasses purchased this week:
0 @ $14:
0 @ $15:
25 @ 16:
-
-
$400
Total COGS: $400


Similarly, Ending Inventory is based on the cost flow assumption that the last items in were sold, and the first items in are still here (FISH):

Sunglasses Purchased two months ago:Sunglasses Purchased one month ago:Sunglasses purchased this week:
240 @ $14:
240 @ $15:
215 @ $16:
$3,360
$3,600
$3,440
Ending Inventory: $10,400


Note that both the actual physical flow of inventory and LIFO result in total goods of $10,800, but LIFO assigns more to cost of goods sold and less to ending inventory during rising prices.



Strengths and Weaknesses of the Last in First Out Method
Last in First Out Strengths:
  • The last in first out method more accurately matches current costs (COGS) with revenue, thus providing the better measure of real gross profit during rising prices.

  • During periods of rising prices, using the last in first out method results in a lower income tax liability when compared to other alternatives. (However, during deflationary periods, the opposite is true).

Last in First Out Weaknesses:
  • Last in first out potentially misstates current inventory costs on the balance sheet when prices rise, since it assigns prices to inventory from earlier periods.

  • Because the origins of the last in first out method come from the Internal Revenue Code, LIFO is subject to more complex IRS regulations and requirements than other alternatives.


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