LIFO method

LIFO is one of the methods of accounting for inventory and its disposal. It can be used for the valuation of both goods and products as well as materials. In general, this technique assumes that the newest iteam entering warehouse is going to be used or sold first. Therefore, the abbreviation LIFO comes from English phrase Last-In, First-Out.

LIFO vs. FIFO

The opposite method to the LIFO is FIFO (First-In, First-Out). Intuitionally, the valuation of inventory under FIFO is carried out on the basis of assumption connected with the chronological flow of costs. It is based on the idea of posting expenditures, starting with the item that was first received in the warehouse. This concept stands in total contradiction to LIFO method that works the other way round. Nonetheless, it is specially useful in case of goods that are perishable in nature. With handling first the earliest stock, the risk of obsolescence diminishes. At this point it is also worth to mention another leading difference of those two concepts, mainly their applicability. It should be underlined that International Financial Reporting Standards prohibit the use of the LIFO method. Therefore, only entities falling under the jurisdiction of U.S. generally accepted accounting principles (GAAP) may apply it.

Reasons for using LIFO

There is no one best method of inventory valuation – each of them is suitable under specific circumstances. In general, inventory valuation is an important aspect in any business as prices constantly fluctuate. For that reason, each entity is responsible for ensuring the transparency of its financial statements by adopting specific accounting standards and, consequently, inventory valuation method. Although LIFO is prohibited by IFRS, there still exist some advantages claimed for LIFO over FIFO. It is believed that due to its nature it provides the best matching of current costs with current revenues than any other metod. What is more, it is also counter-cyclical. During periods of boom connected with inflation, it allows companies to post lower profits than under the FIFO method, therefore incurring so-called tax opportunities.

Example of application

The production company ABC buys material X necessary to be used in the production process . For the valuation of its inventory the company ABC uses LIFO method. In April, company ABC bought 20kg of material X for 45$, in May another 20kg this time for 55$ whereas in June it was decided to buy 45kg as the price fell to 40$. On the other hand, in July the same company managed to process under manufacturing operations 70kg of material X. What was the cost of material X consumption in the production process?

Data
Purchase month	Quantity (kg)	Price (per kg)	Value
April	20	45$	20*45$=900$
May	20	55$	20*55$=1100$
June	45	40$	45*40$=1800$

Solution: Consumption cost of material X reported in July: 45*40$+20*55$+5*45$ = 3125$ In inventory of company ABC remained 15kg of material X with reported value of: 15*45$ = 675$

References

• Helfert E. A. (2001), Financial Analysis Tools and Techniques: A Guide for Managers, Published by McGraw Hill Professional, p. 140-141
• Henderson S., Peirson G., Herbohn K., Howieson B. (2015), Issues in Financial Accounting, Published by Pearson Higher Education AU, p. 160
• Khan M. Y., Jain P. K. (2010), Management Accounting, Published by Tata McGraw-Hill Education, p. 825

Author: Paulina Załubska