LAST-IN, FIRST-OUT (LIFO)

LAST-IN, FIRST-OUT (LIFO). LIFO is the opposite of FIFO: the most recent costs are moved to expense as sales are made.

Theoretically, the LIFO assumption is often justified as more in line with the matching principle. Shirt One

was bought on October 26 whereas Shirt Two was not acquired until December 29. Revenue was earned on

December 31. Proponents of LIFO argue that matching the December 29 cost with the December 31 revenue is

more appropriate than using a cost incurred months earlier. According to this reasoning, income is more properly

determined with LIFO because a relatively current cost is shown as cost of goods sold rather than a figure that is

out-of-date. The difference is especially apparent in periods of high inflation. “By matching current costs against

current sales, LIFO produces a truer picture of income; that is, the quality of income produced by the use of LIFO

is higher because it more nearly approximates disposable income” (Rumble, 1983). Note 1 to the 2008 financial

statements for ConocoPhillips reiterates that point: “LIFO is used to better match current inventory costs with

current revenues.”

The last cost incurred in buying two blue shirts was $70 so that amount is reclassified to expense at the time of

the first sale.

Figure 9.2 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using LIFO

Although the physical results of these transaction are the same (one unit was sold, one unit was retained, and the

company holds $110 in cash), the financial picture painted using the LIFO cost flow assumption is quite different

from in the earlier FIFO example.

LIFO

Cost of Goods Sold (One Unit—the Last One) $70

Gross Profit ($110 Less $70) $40

Ending Inventory (One Unit—the First One) $50

Characteristics commonly associated with LIFO can be seen in this example. When prices rise, LIFO companies

report lower net income (the most recent and, thus, the most costly purchases are moved to expense) and a lower

inventory account on the balance sheet (because the earlier and cheaper costs remain in the inventory T-account).

As will be discussed in a subsequent section, LIFO is popular in the United States because it helps reduce the

amount companies pay in income taxes.