Definition
The financial accounting term last-in, first-out refers to one of several acceptable approaches to inventory valuation. The last-in, first-out method assumes the newest items held in inventory are the first items to be sold when determining the value of this asset as it appears on a company's balance sheet.
Explanation
Also referred to as LIFO, the last-in, first-out method assumes the newest items held in stock are the first items to be sold. This is an assumption used to value the company's inventory; the physical flow of items from inventory may differ from this valuation technique.
While this approach might seem counter-intuitive, there are strong arguments that support the LIFO method. Proponents of LIFO believe that income values should be based on current market costs. That is to say, current revenues should be aligned with current costs.
Accurate inventory valuation will ensure the proper reporting of assets on the company's balance sheet. It's also important to understand the ending inventory value for one year is the beginning inventory value in the following year. Inventory errors likewise have an effect on net income. For example, if the beginning inventory is understated, net income in that period will be overstated.
Example
The following table illustrates the LIFO approach to valuing inventory. Company A begins the year with 250 units, adds 400 units throughout the year, and sells 500 units. The ending inventory for Company A is 150 units.
Units | Cost per Unit | Total Cost | |
Beginning Inventory | 250 | $700 | $175,000 |
Additions on March 1 | 100 | $725 | $72,500 |
Additions on June 1 | 100 | $750 | $75,000 |
Additions on September 1 | 100 | $775 | $77,500 |
Additions on December 1 | 100 | $800 | $80,000 |
Goods Available for Sale | 650 | $480,000 | |
Units Sold | 500 | ||
Units from Beginning Inventory | 150 | $700 | $105,000 |
Ending Inventory | 150 | $105,000 |
The above ending inventory of $105,000 can be used along with the cost of goods available for sale ($480,000) to determine the Cost of Goods Sold:
= Cost of Goods Available for Sale - Ending Inventory = $480,000 - $105,000, or $375,000
Related Terms
The financial accounting term inventory is used to describe the balance sheet line item that includes the value of raw materials, work in process, finished goods ready for sale, and returned goods that can be resold.
Moneyzine EditorNovember 6th, 2024
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