The last in, first out (LIFO) method of inventory valuation is prohibited under International Financial Reporting Standards (IFRS), though it is permitted in the United States, which uses generally accepted accounting principles (GAAP).

IFRS prohibits LIFO due to potential distortions it may have on a company's profitability and financial statements. For example, LIFO can understate a company's earnings for the purposes of keeping taxable income low. It can also result in inventory valuations that are outdated and obsolete. Finally, in a LIFO liquidation, unscrupulous managers may be tempted to artificially inflate earnings by selling off inventory with low carrying costs. We explain further below.

Understated Net Income

LIFO is based on the principle that the latest inventory purchased will be the first to be sold. Let's examine how LIFO vs. first in, first out (FIFO) accounting impacts a hypothetical company, Firm A.

Firm A Inventory Transactions
Purchase Year Units Purchased Cost Per Unit Total Cost of Inventory
Year 1 1,000 $1.00 $1,000
Year 2 1,000 $1.15 $1,150
Year 3 1,000 $1.20 $1,200
Year 4 1,000 $1.25 $1,250
Year 5 1,000 $1.30 $1,300

Now assume Firm A sells 3,500 units in Year 5 at $2.00 per unit. This gives the company $7,000 in revenue. Under FIFO, the total cost of goods sold (COGS) would be caclulated as follows:

Year 1 1,000 x $1.00 $1,000
Year 2 1,000 x $1.15 $1,150
Year 3 1,000 x $1.20 $1,200
Year 4 500 x $1.25 $625
Total Cost of Goods Sold     $3,975

Total gross profit would be $3,025, or $7,000 in revenue – $3,975 cost of goods sold. The value of the remaining inventory is $1,925. That's 500 units from Year 4 ($625), plus 1,000 units from Year 5 ($1,300).

Under LIFO, however, the total cost of goods would be calculated this way:

Year 5 1,000 x $1.30 $1,300
Year 4 1,000 x $1.25 $1,250
Year 3 1,000 x $1.20 $1,200
Year 2 500 x $1.15 $575
Total Cost of Goods Sold     $4,325

Total gross profit would be $2,675, or $7,000 in revenue – $4,325 cost of goods sold. The value of the remaining inventory would be $1,575. That's 1,000 units from Year 1 ($1,000), plus 500 units from Year 2 ($575).

As you can see, Firm A appears more profitable under FIFO, even though the company has sold the exact same number of units. It may seem counterproductive for management to seemingly underreport profit, but the benefit of LIFO stems from the tax benefits. Because the higher COGS has the effect of lowering gross profits, companies that use LIFO are able to lessen their tax bill. But this decrease in tax liability comes at a price: a heavily outdated inventory value.

Outdated Balance Sheet

The other thing that happens with LIFO is the inventory value as reflected on the balance sheet becomes outdated. For example, imagine that Firm A buys 1,500 units of inventory in Year 6 at a cost of $1.40.

Under FIFO, the company's inventory would be valued as follows:

Year 4 500 x $1.25 $625
Year 5 1,000 x $1.30 $1,300
Year 6 1,500 x $1.40 $2,100

But under LIFO, the inventory situation looks like this:

Year 1 1,000 x $1.00 $1,000
Year 2 500 x $1.15 $575
Year 6 1,500 x $1.40 $2,100

Now let's say Firm A then sells 1,500 units in Year 6. Under FIFO, Firm A doesn't touch any of the inventory it added in Year 6. It still has units remaining from Years 4 and 5. Therefore, its COGS would $1,925 (or $625 + $1,300). The value of its remaining inventory is $2,100 i.e. all the units added in Year 6.

However, under LIFO, Firm A pulls directly from Year 6 inventory. It's COGS is $2,100. The value of its remaining inventory is $1,575—i.e. old stock from Years 1 and 2.

The balance sheet under LIFO clearly represents outdated inventory that is four years old. Furthermore, if Firm A buys and sells the same amount of inventory every year, leaving the residual value from Year 1 and Year 2 untouched, its balance sheet would continue to deteriorate in reliability.

LIFO Example: ExxonMobil

This scenario occurs in the 2010 financial statements of ExxonMobil (XOM), which reported $13 billion in inventory based on a LIFO assumption. In the notes to its statements, Exxon disclosed the actual cost to replace its inventory exceeded its LIFO value by $21.3 billion. As you can imagine, under-reporting an asset's value by $21.3 billion can raise serious questions about LIFO's validity.

LIFO Liquidations

Outdated inventory valuations can seriously distort a company's true financial picture when the assets are finally sold. This brings to light another contentious point towards LIFO: LIFO liquidations. Let's go back to our earlier example of Firm A. In Year 6, it manages to sell out all 3,000 units of inventory at $2 each, for $6,000 in revenue.

Under FIFO, its COGS would look like this:

Year 4 500 x $1.25 $625
Year 5 1,000 x $1.30 $1,300
Year 6 1,500 x $1.40 $2,100
COGS     $4,025

Therefore, its gross profit from selling out its inventory would be $1,975, or $6,000 in revenue – $4,025 in COGS.

Under LIFO, Firm A's COGS would be calculated like this:

Year 1 1,000 x $1.00 $1,000
Year 2 500 x $1.15 $575
Year 6 1,500 x $1.40 $2,100
COGS     $3,675

Therefore, its gross profit would be markedly higher at $2,325, or $6,000 in revenue – $3,675 in COGS.

When a LIFO liquidation has occurred, Firm A looks far more profitable than it would under FIFO. This is because old inventory costs are matched with current revenue. However, it's a one-off situation and unsustainable because the seemingly high profit cannot be repeated.

In tough times, management could be tempted to liquidate old LIFO layers in order to temporarily goose profitability. As an investor, you can tell whether a LIFO liquidation has occurred by examining the footnotes of a company's financial statements. A tell-tale sign is a decrease in the company's LIFO reserves (i.e. the difference in inventory between LIFO and the amount if FIFO was used).

Bottom Line

While some might argue that LIFO better reflects actual existing costs to purchase inventory, it is evident that LIFO has several shortcomings. LIFO understates profits for the purposes of minimizing taxable income, results in outdated and obsolete inventory numbers, and can create opportunities for management to manipulate earnings through a LIFO liquidation. Due to these concerns, LIFO is prohibited under IFRS.