LIFO – What is LIFO?
LIFO is a method of stock valuation that stands for ‘Last-In, First-Out’ wherein the units of stock (newest) that were most recently produced or received are the items to be recorded as sold first
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Under the LIFO method of stock management a company assumes that the newest units in stock are the ones being sold first – regardless of which units are actually sold first and are recorded appropriately in the books.
This way, if the price of production or the wholesale purchase cost of these items was different than the current price, then you will account for these goods as the most recent value – not the previous one.
LIFO is the opposite of the FIFO valuation method, which conversely assumes that the oldest recorded cost of units in stock are those being sold first and should be recorded as such.
The LIFO and FIFO Methods are accounting techniques used in managing a company’s stock and financial matters. They help a company determine the value of their stock, raw materials, etc. They are used to manage cost flows assumptions related to stock and stock repurchases (if purchased at different prices).
LIFO vs. FIFO example
To show the difference between LIFO and FIFO, let’s use the example of a company that produces socks. Let’s say that this company produces 500 pairs of socks on Monday at a cost of £1.00 each, and 500 more on Tuesday at £1.25 each. Now they have 1,000 pairs of socks in stock worth £1,125.00.
LIFO states that if the company then sold 500 pairs of socks on Wednesday, their cost of goods sold for those 500 pairs is £1.25 per widget, or £625.00 (recorded on the income statement). That’s because £1.25 was the cost of each of the last pairs in their stock.
The remaining 500 pairs of socks would then be allocated to the company’s ending stock at £1.00 each (recorded on the balance sheet), resulting in an ending stock balance of £500.00.
If the totals of the assets sold totals more than what was paid for them, then this is considered a capital gain and can be taxable. Conversely, if the LIFO assets are sold for less than the price they were purchased for, this would be considered a capital loss.
LIFO banned by the IFRS
Around the 1970s, companies in the United States began shifting towards the use of LIFO, since valuating their stock this way reduced their income taxes during times of inflation. The International Financial Reporting Standards (the IFRS) soon banned the use of LIFO however, which has resulted in many US companies returning to FIFO.
LIFO is only used in Japan and the U.S. It is not applicable in the United Kingdom, where stock valuation is typically recorded by either the average cost or FIFO valuation method.