last-in_first-out_lifo [CapiPedia]

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======Last-In, First-Out (LIFO)======
Last-In, First-Out (LIFO) is an [[Inventory]] accounting method that operates on a simple, if sometimes counterintuitive, principle: the last item you bought is the first one you sell. Imagine a pile of coal at a power plant. New coal is constantly dumped on top of the pile, and when the plant needs fuel, it scoops from the top. The newest coal is used first, while the old stuff sits at the bottom. In accounting terms, LIFO assumes that the most recently acquired inventory costs are the first to be moved to the [[Cost of Goods Sold (COGS)]] on the income statement. This means the costs you match against your revenue are the most current ones. This method is primarily used for financial reporting and tax purposes and often does not reflect the actual physical flow of goods, where older stock is typically sold first to avoid spoilage or obsolescence.
===== The LIFO Logic: Selling the Newest Stuff First =====
To understand LIFO, let's run a T-shirt shop. You are preparing for the summer season and buy your shirts in three batches as prices rise.
  * **January:** 100 shirts at €10 each.
  * **March:** 100 shirts at €12 each.
  * **May:** 100 shirts at €15 each.
Now, you sell 150 shirts in June. How do you calculate your cost? With LIFO, you assume you sold your //newest// inventory first.
  - First, you account for the 100 shirts from May: 100 shirts x €15 = €1,500
  - Then, you account for the remaining 50 shirts from the next most recent batch (March): 50 shirts x €12 = €600
Your total COGS for the 150 shirts sold would be €1,500 + €600 = **€2,100**.
What's left in your inventory? You have the 100 shirts from January (€10 each) and 50 shirts from March (€12 each). The inventory value on your [[Balance Sheet]] would be (€10 x 100) + (€12 x 50) = **€1,600**.
===== LIFO's Impact on the Financial Statements =====
The choice between LIFO and its counterpart, [[First-In, First-Out (FIFO)]], isn't just an accountant's parlor game; it has real-world consequences for a company's reported profits, taxes, and balance sheet strength.
==== The COGS and Profit Connection ====
During periods of rising prices, known as [[Inflation]], LIFO produces a higher COGS than FIFO. As seen in our T-shirt example, matching the latest, most expensive costs (€15 and €12) against revenue leads to a higher expense.
  * **Higher COGS** leads to...
  * **Lower [[Gross Profit]]**, which in turn leads to...
  * **Lower reported [[Net Income]]**.
While lower profits might sound bad, there's a silver lining for the company: a lower tax bill. This tax benefit is the primary reason many U.S. companies stick with LIFO. Conversely, during periods of deflation (falling prices), LIFO would result in lower COGS and higher reported profits.
==== The Balance Sheet and Inventory Value ====
The flip side of LIFO is its effect on the balance sheet. Because the older, cheaper inventory is what remains on the books, LIFO can significantly understate the true economic value of a company's inventory. In our example, the remaining inventory is valued at €1,600, but its current replacement cost would be much higher. This creates what's known as "LIFO liquidation" risk, where a company might have to dip into old inventory layers, causing a sudden, artificial spike in reported profits and a big tax bill.
===== LIFO for the Value Investor: A Red Flag? =====
For a [[Value Investing]] practitioner, a company using LIFO requires a bit of detective work. LIFO reporting can obscure a company's true profitability and asset value, creating both pitfalls and opportunities.
==== The Trouble with LIFO in an Inflationary World ====
A company using LIFO might look less profitable than a competitor using FIFO, purely because of its accounting choice. The inventory on its balance sheet will also look deceptively low. This is a classic case of accounting earnings differing from economic reality. The savvy investor needs to look past the reported numbers.
==== Comparing Companies: The LIFO vs. FIFO Puzzle ====
How can you compare a LIFO company to a FIFO company? The key is the **[[LIFO Reserve]]**. This is a figure that LIFO companies must disclose in the footnotes of their financial statements. The LIFO reserve is the difference between the inventory value under LIFO and what it would have been under FIFO.
To make an apples-to-apples comparison, you can make two key adjustments:
  * **Balance Sheet:** Add the LIFO reserve to the LIFO company's reported inventory value.
  * **Income Statement:** Adjust the COGS and, consequently, the net income to see what they would have been under FIFO.
This adjustment reveals the true economic value of the inventory and provides a more accurate picture of profitability, allowing for a fair comparison with peers.
===== The Global Picture: Where is LIFO Used? =====
One of the most important facts about LIFO is its geographic limitation.
  * It is permitted under **[[U.S. Generally Accepted Accounting Principles (U.S. GAAP)]]**.
  * It is //banned// under **[[International Financial Reporting Standards (IFRS)]]**, which are used by most other countries, including the entire European Union.
This discrepancy is a major hurdle in comparing U.S. companies with their international counterparts. If you're analyzing a U.S. retailer and a European one, you must be aware of this difference and adjust the U.S. company's figures to a FIFO basis to get a clear and comparable view.