Legal Definitions - LIFO accounting

LIFO accounting, which stands for Last In, First Out, is an inventory valuation method used by businesses to determine the cost of goods sold and the value of their remaining inventory. Under LIFO, it is assumed that the most recently purchased or produced items are the first ones to be sold or used. This accounting method can be particularly advantageous during periods of inflation, as it tends to assign higher costs (from the most recent purchases) to the goods sold, thereby reducing a company's reported taxable income and potentially lowering its income tax liability.

• Example 1: Construction Materials Supplier

  Imagine a large lumber yard that purchases several shipments of identical wooden beams throughout the year. Due to increasing demand and raw material costs, each new shipment of beams costs more per unit than the previous one. When the lumber yard sells a quantity of these beams to a construction company, LIFO accounting assumes that the beams sold came from the most recent, most expensive shipment. This means the higher cost of the newer beams is immediately recognized as a cost of goods sold, which reduces the lumber yard's reported profit for tax purposes, even if physically, they might have sold older stock.

• Example 2: Electronics Retailer

  Consider an electronics store that buys a popular model of laptop. In January, they purchase 100 units at $800 each. In March, due to a price increase from the manufacturer, they purchase another 100 units of the exact same laptop model at $850 each. If the retailer sells 50 laptops in April, LIFO accounting would assume these 50 laptops were from the March batch (the "last in" at $850 each). This higher cost ($850 per laptop) is then used to calculate the cost of goods sold, resulting in a lower reported gross profit compared to if they had assumed the laptops sold were from the cheaper January batch. This can lead to a lower tax bill during periods of rising inventory costs.

• Example 3: Fuel Distributor

  A regional fuel distributor regularly purchases large quantities of gasoline from refineries. Over a month, the wholesale price per gallon increases with each new delivery. When the distributor sells gasoline to local gas stations, LIFO accounting dictates that the cost associated with the sold fuel is based on the most recent, higher-priced deliveries. By matching these higher, more current costs against their sales revenue, the distributor reports a lower net income, which can be beneficial for tax planning, especially when fuel prices are volatile and generally trending upwards.