When & Why Should a Company Use LIFO

LIFO, which stands for last in, first out, is a controversial way of accounting for how inventory has been sold. The method is banned under the International Financial Reporting Standards (IFRS) which are the accounting rules followed in the European Union, Japan, Russia, Canada, India, and many other countries. The United States, which follows GAAP (Generally Accepted Accounting Principles), is the only country that allows LIFO. So when and why should a company use LIFO?

Under LIFO, a business records its newest products and inventory as the first sold. The opposite approach is called FIFO, which stands for first-in, first out. Under FIFO, the oldest inventory is recorded as the first sold. In either case, the business may not be literally selling the newest or oldest inventory, but it is using that assumption for cost accounting purposes. If the cost of buying inventory were the same every year, it would make no difference whether a business used LIFO or FIFO. But costs do change. For many products, costs rise every year. Businesses that sell those products benefit from using LIFO.

Opponents of LIFO say that it distorts inventory figures on the balance sheet in times of inflation. They also claim LIFO gives its users an unfair “tax holiday” as it can lower net income, and subsequently, the taxes a firm faces. This is exactly why business like LIFO. By using LIFO when prices are rising, firms can better match their revenues to their latest costs, save on taxes that otherwise would have been accrued under other forms of cost accounting, and undertake fewer inventory write downs.

Virtually any industry that faces rising costs can make a case for using LIFO cost accounting. For example, 90 percent of supermarkets and the majority of drug stores use LIFO as almost every good they carry has experienced inflation. Furthermore, convenience stores, especially those that carry fuel and tobacco, are also good LIFO candidates as the costs of these products have risen over time. Certain industries, such as mining and lumber, also prefer to use LIFO as they stack their heavy inventory in piles, and tend to sell off the newest inventory (at the top of the pile) first.

For the aforementioned companies, the use of LIFO allows them to better match their revenues to their latest costs, as well as receive a tax break on inflation. Let’s take a look at a hypothetical company called One Cup, Inc. It buys coffee mugs from wholesalers and sells them on the Internet. We will see how One Cup's costs of goods sold (COGS) differs when it uses LIFO versus when it uses FIFO. In one scenario, the price of wholesale mugs is rising from 2011 to 2014. In the second scenario, prices are falling between 2011 and 2014. 

RISING PRICES

FALLING PRICES

In 2015, One Cup sells 250 mugs on the Internet. Under LIFO, the cost of good sold = the total cost of the 100 mugs purchased from the wholesaler in 2014 + cost of 100 mugs purchased in 2013 + cost of 50 of the 100 mugs purchased in 2012. Under FIFO, the cost of good sold = total cost of 100 mugs purchased in 2011 + cost of 100 mugs purchased in 2012 + cost of 50 of the 100 mugs purchased in 2013. In the next table, we will see how the cost of goods sold under LIFO and FIFO changes according to whether wholesale mug prices are rising or falling. 

As you can see, during times of inflation, costs of goods sold are higher under LIFO than under FIFO. This is because the last purchased items are sold off first: 100 units from 2014, 100 units from 2013 and 50 units from 2012. Under FIFO, 100 units from 2011,100 units from 2012, and 50 units from 2013’s prices are combined to make the 250 unit order. Under falling prices, the converse is true: the costs of good sold are lower under LIFO and higher under FIFO. Therefore in times of inflation, the costs of good sold under LIFO better represents the real-world costs to replace the inventory. This adheres to what is called the matching principle of accrual accounting.

As seen above, the higher costs of good sold under LIFO decreases net profits and subsequently, creates a lower tax bill for One Cup. This is the major point of controversy surrounding LIFO: opponents argue that LIFO grants an unfair tax holiday for firms during prices times of inflation. Proponents counter that this tax savings is reinvested by the firm and is of no real consequence to the economy. Furthermore, proponents counter that the tax bill that is accrued by the firm when operating under FIFO is an unfair tax due to inflation.

One final reason to use LIFO over FIFO is that there are fewer inventory write-downs under LIFO during inflation. An inventory write-down occurs when the inventory is deemed to have decreased in price below its carrying value. Generally Accepted Accounting Principles (GAAP) defines inventory carrying amounts as the lower of cost or market. 

Market is constrained between an upper and lower bound: the net realizable value (the selling price less reasonable costs of completion and disposals) and the net realizable value minus normal profit margins. In inflationary conditions, the carrying amount of the inventories on a balance sheet already reflect the oldest costs of carry and are the most conservative inventory values. Therefore, under LIFO, write-downs of inventory are usually unnecessary and rarely undertaken.

Moreover, as write-downs can reduce profitability (by increasing the costs of goods sold) and assets (decrease inventories), solvency, profitability and liquidity ratios can all be negatively impacted. GAAP prohibits reversals of write-downs. So firms that report under GAAP must ensure that write-downs are absolutely necessary because they have permanent consequences.

During times of rising prices, companies may find it beneficial to use LIFO cost accounting over FIFO. Under LIFO, whenever prices are rising, firms can save on taxes as well as better match their revenues to their latest costs. In addition, industries with a high risk of inventory obsolescence can use LIFO accounting to either limit or not undertake inventory write-downs.