Last In First Out Method (LIFO
Method):
Learning objectives of this article:
-
Define and explain last in first out (LIFO)
method.
-
How periodic and perpetual inventory systems
impact this inventory valuation method.
-
What are advantages and disadvantages of LIFO
method?
Definition and Explanation:
The
last in first out (LIFO) method first matches
against revenue the cost of the last goods
purchased. It a periodic inventory system is used,
then it would be assumed that the cost of the total
quantity sold or issued during the month have come
from the most recent purchases. The ending inventory
would be priced by using the total units as a basis
of computation and disregarding the exact dates
involved.
Example:
Assume
that a company had the following transactions in the
first month of operations.
Date |
Purchases |
Sold
or Issued |
Balance |
March
2 |
2,000
@ $4.00 |
|
2,000
units |
March
15 |
6,000
@ $4.40 |
|
8,000
units |
March
19 |
|
4,000
units |
4,000
units |
March
30 |
2,000
@ $4.75 |
|
6,000
units |
|
Periodic Inventory System:
Assume
that the cost of the 4,000 units withdrawn on
absorbed the 2,000 units purchased on March 30 and
2,000 units of the 6,000 units purchased on March
15. The inventory and related cost of goods sold
would then be computed as shown below:
Date
of Invoice |
No.
Units |
Unit
Cost |
Total
Cost |
March
2 |
2,000 |
$4.00 |
8,000 |
March
15 |
4,000 |
$4.40 |
17,600 |
|
|
|
|
Ending
inventory |
6,000 |
|
$25,600 |
|
|
|
|
Goods
available for sale |
$43,900 |
|
Deduct: Ending inventory |
25,600 |
|
|
|
|
|
|
|
$18,300 |
|
|
|
|
|
|
Perpetual Inventory System:
If a perpetual inventory record is kept in
quantities and dollars, application of the last in
first out method will result in different inventory
and cost of goods sold amounts as shown below:
Date |
Purchases |
Sold or Issued |
|
Balance |
|
March
2 |
(2,000
@ $4.00) $8,000 |
|
|
(2,000
@ $4.00) |
$8,000 |
March
15 |
(6,000
@ $4.40) $26,400 |
|
|
(2,000
@ $4.00)
(6,000
@ $4.40) |
$34,400 |
March
19 |
|
(4,000
@ $4.40) |
$17,600 |
(2,000
@ $4.00)
(2,000
@ $4.40) |
$16,800 |
March
30 |
(2,000
@ $4.75) $9,500 |
|
|
(2,000
@ $4.00)
(2,000
@ $4.40)
(2,000
@ $4.75) |
26,300 |
|
The
month-end periodic inventory computation
presented above (inventory $25,600 and cost
of goods sold $18,300) shows a different
amount from the perpetual inventory
computation (inventory $26,300 and cost of
goods sold $17,600). This is because the
periodic system matches the total
withdrawals for the month with the total
purchases for the month in applying the last
in first out method. In contrast, the
perpetual system matches each withdrawal
with the immediately preceding purchases. In
effect, the periodic computation assumed
that the cost of the goods that were
purchased on March 30 were included in the
sale or issue on March 19.
Advantages of Last in First Out LIFO) Method:
One obvious
advantage of LIFO approach is that in certain
satiations the LIFO cost flow actually approximates
the physical flow of the goods in and out of
inventory. For example, in the case of a coal pile,
the last coal in is the first coal out because it is
on the top of the pile. The coal remover is not
going to take the coal from the bottom of the top of
the pile. The coal that is going to be taken first
is the coal that was placed on the pile last. How
ever the coal pile situation is one of the only a
few situations where the actual physical flow
corresponds to LIFO. Therefore most adherents of
LIFO use other arguments for its widespread
employment, as follows: Matching:
In LIFO, the more
recent costs are matched against current revenues to
provide a better measure of current revenues. During
periods of inflation, many challenge the quality of
non-LIFO earnings, noting that by failing to match
current costs against current revenues, transitory
or "paper" profits ("inventory profits") are
created. Inventory profits occur when the inventory
costs matched against sales are less than the
inventory replacement cost. The cost of goods sold
therefore is understated and profit is overstated.
Using LIFO (rather than a method such as FIFO),
current costs are matched against revenues and
inventory profits are thereby reduced. Tax
Benefits/Improved Cash Flow:
Tax benefits are
the major reason why LIFO has become popular. As
long as the price level increases and inventory
inventory quantities do not decrease, a deferral of
income tax occurs, because the items most recently
purchased at the higher price level are matched
against revenues. Future Earnings Hedge:
With LIFO, a
company's future reported earnings will not be
affected substantially by future price declines.
LIFO eliminates or substantially minimizes
write-downs to market as a result of price
decreases. Since the most recent inventory is sold
first, there is not much ending inventory sitting
around at high prices vulnerable to a price decline.
In contrast, inventory costed under FIFO is more
vulnerable to price decline, which can reduce net
income substantially. Disadvantages of
Last In First Out Approach:
Despite its
advantages, LIFO has the following drawbacks:
Many corporate
managers view the lower profits reported under the
LIFO method in inflationary times as a distinct
disadvantage. They would rather have higher reported
profits than lower taxes. Some fear that an
accounting change to LIFO may be misunderstood by
investors and that, as a result of the lower
profits, the price of the company's stock will fall.
In fact, though, there is some evidence to reduce
this contention. Inventory Understated:
LIFO may have a
distorting effect on the company's balance sheet.
The inventory valuation is normally outdated because
the oldest costs remain in the inventory. This
understatement makes the working capital position of
the company appear worse than it really is. The
magnitude and direction of this variation between
the carrying amount of inventory and its current
price depend on the degree and direction of the
price changes and the amount of inventory turnover.
The combined effect of rising product prices and
avoidance of inventory liquidations increases the
difference between the inventory carrying value at
LIFO and current prices of that inventory, thereby
magnifying the balance sheet distortion attributed
to the use of last in first out method.
Physical Flow:
LIFO does not
approximate the physical flow of the items except in
peculiar situations (such as the coal pile).
Originally LIFO could be used in certain
circumstances. This situation have changes over the
years to the point where physical flow
characteristics no longer play an important role in
determining whether LIFO may be employed.
Involuntary Liquidation/Poor Buying Habits:
If the base or layers
of old costs are eliminated, strange results can
occur because old, irrelevant costs can be
matched against current revenues. A distortion in
reported income for a given period may result, as
well as consequences that are detrimental from an
income tax point of view.
Because of liquidation
problem, LIFO may cause poor buying habits. A
company may simply purchase more goods and match
these goods against revenue to ensure that the old
costs are not charged to expense. Furthermore, the
possibility always exists with LIFO that a company
will attempt to manipulate its net income at the end
of the year simply by altering its pattern of
purchases.
Why do Companies Reject Last In First Out Method?
Summary of responses
Reasons to Reject LIFO |
Number |
% of Total* |
No expected tax benefits |
|
|
No required tax payment |
34 |
16% |
Declining prices |
31 |
15 |
Rapid inventory turnover |
30 |
14 |
Immaterial inventory |
26 |
12 |
Miscellaneous tax related |
38 |
17 |
|
|
|
|
159 |
74% |
Regulatory or other
restrictions |
26 |
12% |
Excessive cost |
|
|
High administrative costs |
29 |
14% |
LIFO liquidation-related
costs |
12 |
6 |
|
|
|
|
41 |
20% |
Other adverse consequences |
|
|
Lower reported earnings |
18 |
8% |
Bad accounting |
7 |
3 |
|
|
|
|
25 |
11% |
|
|
|
|
*Percentage
totals more than 100% as some companies
offered more than one explanation. |
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