What Is LIFO Accounting?
LIFO is an acronym for Last-In, First-Out and it describes a method of accounting based on the assumption that the newest inventory purchases are sold before earlier inventory purchases. Under this approach, the most recently acquired or produced items are the first to pass through cost of goods sold. In other words, the most recent inventory costs are matched against current revenues on the income statement, while the older costs remain on the balance sheet.
This method becomes particularly significant during periods of inflation. When prices are rising, using LIFO typically results in higher cost of goods sold and lower profits, because the newest inventory, which is sold first, is more expensive. As a result, it can reduce a company’s taxable income and therefore, its tax liability. However, it can also result in an inventory valuation on the balance sheet that is out of sync with the current net realizable value.
LIFO & FIFO
FIFO is an acronym for First In, First Out which is the direct opposite inventory method to LIFO as it assumes the first inventory purchased is the first sold. During inflation, the FIFO accounting approach will lead to higher values on ending inventory as opposed to the LIFO approach with more cost capitalization on inventory but lower tax savings benefits.
This makes LIFO a more advantageous method, particularly as prices rise, because it places a lower value on remaining inventory which equals a higher Cost of Goods Sold. That can have a direct effect on reducing a company’s taxable income and the amount of tax owed for the year.
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