LIFO

LIFO stands for "Last in, first-out" and is one method to determine the value of the inventory on a company's balance sheet and to calculate the cost of goods sold (COGS).

Expanded Definition

Inventory and COGS

LIFO is one of the two primary ways of tracking inventory on the balance sheet. (The other is the FIFO (first-in, first-out) method, and some companies use the average cost method.) The last inventory purchased is considered the the first sold, regardless if the items sold were physically the last ones purchased or not. In other words, this is an accounting method, not a physical tracking method. So, it doesn't necessarily reflect reality.

Most U.S. companies use LIFO because it results in lower taxes. However, most foreign companies use FIFO because it paints a more accurate picture of inventory costs.

A corporation that uses LIFO must use it consistently (i.e. it can't use LIFO on it's annual statements but tell the taxman the FIFO number).

An example of how it works

Suppose XYZ company sells Gizmos. It tracks actual inventory as follows, during one quarter:

Under LIFO, you can see that the ones "sold" start at the latest and work their way backward. If an even later purchase happens before the next sale, then those are used (which is why those sold on Day 75 used the $12 Gizmos, not those from the original balance).

The COGS for this quarter can be calculated two ways.

First, take the sum of the costs of the "sold" items from the above tracking table: $5,500 + $7,000 +$2,400 = $14,900. Unless, however, you have access to a table like the above (which you won't), you can't do it this way.

Second, take the total amount spent on new purchases, add beginning inventory, and subtract ending inventory: ($5,500 + $8,400 + $3,900) + $10,000 - $12,900 = $14,900. The individual items purchased won't be available, but the total amount is available from the operating section of the company's statement of cash flow. The beginning and ending inventory balances are available on the balance sheets.

Implications

Note that, as opposed to FIFO (see the similar example on that page), the ending inventory is lower under LIFO and the COGS is higher. A higher COGS results in a lower net income, which means the company ends up paying less income tax. A lower inventory balance affects items such as items such as the cash conversion cycle or days inventory outstanding or other metrics of management effectiveness, when compared to the FIFO method.

LIFO is considered by some to be an example of financial engineering and usually results in lower taxes than FIFO making it a popular choice in The United States. Wal-Mart and Costco both use LIFO. In Europe and elsewhere LIFO is not even allowed for public companies thus making FIFO their overwhelming choice.

LIFO Reserve

Companies that use LIFO must include a LIFO Reserve figure in their statements. This figure shows the difference between what the inventory number would have shown under FIFO. Investors need to pay close attention to this as LIFO reserve can be very substantial and tends to grow as companies grow and costs rise. It is necessary to use this to correct a LIFO-company to FIFO when comparing inventory levels between the two.

Related Fool Articles

Inventory ins and outs

Related Terms

• Average cost method
• FIFO
• Inventory
• LIFO liquidation

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