LIFO Cost Flow Assumption (last-in, first-out)

This cost flow assumption was developed for tax purposes. However, because of tax law requirements, if a company uses this assumption for tax purposes it must also use it for its financial statements. ("LIFO conformity rule") It does not coincide with the actual movement of goods. LIFO is used during inflation to defer income tax payments. Under LIFO the goods in inventory at the beginning of the period are assumed to remain in the ending inventory (perhaps for decades). Obviously, this does not actually happen! Remember, this is an assumption only.

LIFO is a method to defer taxes until the "beginning" inventory is sold (either because the company changes to a different method or because it has not replenished its inventory of the particular goods or class of goods). If this event occurs, the lower cost of goods (based on costs incurred at a much earlier time) will result in higher income and correspondingly higher income taxes. In other words, the taxes deferred during earlier times will now become payable, assuming there have been no changes in tax law/rates.

LIFO requires significant record keeping and careful management of purchases. It also results in significantly understated inventory values (assets) if it has been used for a significant length of time and/or if there is significant inflation. However, it results in significant tax savings (cashflow!).

Related topics: Pooled LIFO | Dollar Value LIFO | $Value Retail LIFO | "Inventory Parking"

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