The Last-In-First-Out (LIFO) method of inventory valuation , while permitted under the US Generally Accepted Accounting Principles (GAAP), is prohibited under the International Financial Reporting Standards (IFRS). As IFRS rules are based on principles rather than exact guidelines, usage of LIFO is prohibited due to potential distortions it may have on a company’s profitability and financial statements. In principle, LIFO may create a distortion to net income when prices are rising (inflation), LIFO inventory amounts are based on outdated and obsolete numbers, and LIFO liquidations may provide unscrupulous managers with the means to artificially inflate earnings.

Understated Net Income

LIFO is based on the principle that the latest inventory that was purchased will be the first to be sold. Let’s take a look at an example of the effects of LIFO accounting vs. First-In-First-Out (FIFO) on a hypothetical company, Firm A:

Firm A inventory Transactions

Purchase at Year

Units Purchased

Costs Per Unit

Total Costs of Inventory

Year 1

1000

$1.00

$1000

Year 2

1000

$1.15

$1150

Year 3

1000

$1.20

$1200

Year 4

1000

$1.25

$1250

Year 5

1000

$1.30

$1300

Now assume Firm A sells 3500 units in Year 5 at $2.00 per unit.

Under FIFO:

Revenue: 3500 x $2.00 = $7,000

Year 1: 1000 x $1.00 = $1000

Year 2: 1000 x$1.15 = $1150

Year 3: 1000 X$1.20 = $1200

Year 4: 500 X$1.25 = $625

Total costs of goods sold (COGS):  $3975

Total gross profits: $7,000 – $3975 = $3025

Value of remaining inventory: $1925 (500 units from Year 4 + 1000 units from Year 5, at their related per-unit costs)

Under LIFO:

Revenue: 3500 x $2.00 = $7,000

Year 5: 1000 x $1.30 = $1300

Year 4: 1000 x $1.25 = $1250

Year 3: 1000 x $1.20 = $1200

Year 2: 500 x $1.15 = $575

Total costs of goods sold (COGS): $4325

Value of remaining inventory: $1575 (1000 units from Year 1 + 500 units from Year 2 at their related per-unit costs)

Gross profits under FIFO: $3975

Gross profits under LIFO: $2675

As you can see, Firm A under FIFO appears more profitable, even though it has sold the exact same number of units in total. On the surface, this may seem counterproductive for management to seemingly underreport the company’s profits, but the benefit of LIFO lies in its tax benefits. With lower gross profits (higher COGS), firms utilizing LIFO are able to decrease their tax liabilities. This decrease in tax liability comes at a price: a heavily outdated inventory value.

Outdated Balance Sheet

LIFO is used by firms to lower their tax liabilities at the expense of an outdated inventory value as reflected on the balance sheet . This raises the possibility of a heavily outdated and subsequently useless inventory valuation. For example, imagine that Firm A buys 1500 units of inventory in Year 6 at a cost of $1.40 and later sells the same number of units.  

Under FIFO, its COGS would be 500 units at $1.25 from Year 4’s remaining inventory and 1000 units at $1.30 from Year 5 for a total of, $1925. Under LIFO, its COGS would be the 1500 units purchased in Year 6 at a cost of $1.40 for a total of $2100. The remaining inventory value under FIFO would be $2100, while the inventory value under LIFO would be 500 units from Year 2 at $1.15 per unit and 1000 units from Year 1 at $1.00 per unit, for a total of $1575. The balance sheet under LIFO clearly represents an outdated inventory value that is four years old! Furthermore, if Firm A buys and sells the same amount of inventory every year (which is a strong possibility if Firm A is an energy company, as they tend to sell the last units acquired first), leaving the residual value from Year 1 and Year 2 untouched, its balance sheet would continue to deteriorate in reliability.

This scenario is quite evident in the 2010 financial statements of ExxonMobil, Corp. (NYSE: XOM), which reported inventory of $13 billion based on a LIFO assumption. In the notes to these statements, Exxon disclosed that the actual current cost of the same inventory was $21.3 billion higher than the number reported. As you can imagine, an asset that is being reported at $13 billion when in fact it is worth $34.3 billion can raise serious questions about LIFO’s validity. Note that if these assets that are represented at seriously outdated numbers are never intended for resale purposes, LIFO valuations would not be an issue. However, from time to time, these outdated assets are resold. This brings to light another point of contention towards LIFO: LIFO liquidations.

LIFO Liquidations

A LIFO liquidation occurs when the previously mentioned outdated assets are sold, but the COGS from these assets are matched with current revenues. Let’s assume Firm A sells 3000 units in Year 6:

Under FIFO:

3000 x $2.00 = $6000 revenues

COGS:

Year 6: 1500 x $1.40 = $2100

Plus remaining Year 4 and Year 5 inventories at their related costs per-unit: $1925

Total: $4025

Gross profits in Year 6: $6000 – $4025 = $1975

Under LIFO:

3000 x $2.0 = $6000 revenues

COGS:

Year 6: 1500 x $1.40 = $2100

Plus remaining Year 1 and Year 2 inventories at their related costs per-unit: $1575

Total: $3675

Gross profits: $2325

When a LIFO liquidation has occurred, Firm A looks far more profitable than if it were to be using FIFO. This is because the old costs are matched with current revenues in a one-time, unsustainable earnings inflation. In times of declining economic activity, there could be pressure on management to purposely liquidate old LIFO layers in order to boost profitability. Further information on whether or not a LIFO liquidation has occurred can be gleaned from footnotes in the financial statements or from decreases within the LIFO reserve (the inventory difference in amount of inventory between LIFO and the amount if FIFO was used). (See Also: Causes of Decline in LIFO Reserve.)

The Bottom Line

While it can be argued that LIFO COGS better reflect actual existing costs to purchase the inventory, it is evident that LIFO has several shortcomings. LIFO understates profits for lower taxable income, discloses 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.  

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