LIFO

LIFO stands for Last-In, First-Out. It is an inventory accounting method where the most recently purchased inventory is assumed to be sold first. When prices are rising, LIFO produces lower reported profit (because newer, higher-cost inventory is expensed) and lower taxes. LIFO is permitted under GAAP in the US but is not permitted under IFRS, which limits its use to US companies. For tax purposes, LIFO is tax-advantaged but requires significant record-keeping. Investors must understand LIFO reserves to compare LIFO companies to FIFO competitors.

How LIFO works

Under LIFO, when a company sells inventory, it assumes the most recently purchased items are sold first. The remaining inventory is valued at the oldest prices.

Example: A retailer buys inventory in this order:

• January: 100 units at $10 = $1,000
• March: 100 units at $12 = $1,200
• June: 100 units at $14 = $1,400

If the company sells 150 units during the year under LIFO, it assumes the 150 units sold are: 100 from June ($14) and 50 from March ($12).

Cost of goods sold = 100 × $14 + 50 × $12 = $1,400 + $600 = $2,000 Remaining inventory = 50 units at $12 + 100 units at $10 = $600 + $1,000 = $1,600

Under FIFO (first-in, first-out), the cost would be different because it assumes the oldest inventory is sold first.

Inflation advantage of LIFO

In inflationary periods, LIFO is tax-advantaged. Because newest (most expensive) inventory is expensed, cost of goods sold is higher, profit is lower, and taxes are lower.

This is the primary reason companies use LIFO: not for accuracy, but for tax savings. A company that uses LIFO for tax purposes must also use it for financial reporting (under IRS rules).

LIFO disadvantage: reserve swaps and other issues

However, LIFO has downsides:

• Layer liquidation: If inventory falls, old, cheap layers are sold, creating inflated profit.
• Complexity: Tracking multiple layers of cost is administratively complex.
• Earnings distortion: LIFO profits depend on inventory purchasing patterns, not just sales.
• Not globally accepted: IFRS does not permit LIFO, limiting comparability.

LIFO reserve

Because LIFO differs from FIFO, the difference is tracked in the LIFO-reserve. The LIFO-reserve is the difference between inventory value under LIFO and under FIFO.

Example: Using the numbers above, remaining inventory under LIFO is $1,600. Under FIFO, it would be valued at: 50 units at $10 + 100 units at $12 = $500 + $1,200 = $1,700.

LIFO-reserve = $1,700 - $1,600 = $100

This reserve is disclosed in footnotes and is useful for comparing LIFO companies to FIFO competitors.

LIFO vs. FIFO in different price environments

In inflationary periods: LIFO produces lower profit and lower taxes (advantage).

In deflationary periods: LIFO produces higher profit and higher taxes (disadvantage).

This is why companies are reluctant to switch from LIFO after using it for years; switching would trigger a one-time tax bill (the LIFO-reserve reverses).

International divergence

Under IFRS, LIFO is not permitted. Companies outside the US and subsidiaries reporting under IFRS must use FIFO or weighted-average.

This is a major source of divergence between GAAP and IFRS. A US company using LIFO must restate to FIFO or weighted-average when filing IFRS statements.

Declining use of LIFO

The number of US companies using LIFO has declined significantly over decades, for several reasons:

• Tax benefits have diminished (lower inflation).
• Administrative complexity discourages new adoption.
• Global companies prefer FIFO or weighted-average for consistency.
• LIFO is allowed under GAAP but not IFRS.

See also