Use of the Last-In, First-Out Method
When the lifo method is used during a period of inflation or rising prices, the results
are opposite those of the other two methods. As shown in the preceding example, the
lifo method will yield a higher amount of cost of merchandise sold, a lower amount of
gross profit, and a lower amount of inventory at the end of the period than the
other two methods. The reason for these effects is that the cost of the most recently ac-
quired units is about the same as the cost of their replacement. In a period of inflation,
the more recent unit costs are higher than the earlier unit costs. Thus, it can be argued
that the lifo method more nearly matches current costs with current revenues earnings
reports. For example, DaimlerChrysler’s reason for changing from the fifo method
to the lifo method was stated in the following note that accompanied its financial
statements:DaimlerChrysler changed its method of accounting from first-in, first-out (fifo) to
last-in, first-out (lifo) for substantially all of its domestic productive inventories.
The change to lifo was made to more accurately match current costs with current
revenues.The rules used for external financial reporting need not be the same as those used
for income tax reporting. One exception to this general rule is the use of lifo. If a firm
elects to use lifo inventory valuation for tax purposes,
then the business must also use lifo for external finan-
cial reporting. This is called the lifo conformity rule.
Thus, in periods of rising prices, lifo offers an income
tax savings because it reports the lowest amount of
net income of the three methods. Many managers elect
to use lifo because of the tax savings, even though the
reported earnings will be lower.
The ending inventory on the balance sheet may
be quite different from its current replacement cost
(or fifo estimate).^2 In such cases, the financial state-
ments will include a note that states the estimated
difference between the lifo inventory and the inven-
tory if fifo had been used. This difference is called
thelifo reserve. An example of such a note for Deere
& Companyis shown below.Most inventories owned by (John) Deere & Company and its United States equipment
subsidiaries are valued at cost, on the last-in, first-out (LIFO) basis.... If all inven-
tories had been valued on a FIFO basis, estimated inventories by major classification
at October 31 in millions of dollars would have been as follows:2004 2003
Raw materials and supplies $ 589 $ 496
Work-in-process 408 388
Finished machines and parts 2,004 1,432
Total FIFO value $3,001 $2,316
Less (lifo reserve) adjustment to LIFO value 1,002 950
Inventories $1,999 $1,366278 Chapter 6 Inventories
2 The fifo equivalent is replacement cost, which is often similar to fifo.International Perspective
International Accounting
Standards (IASs) do not
allow companies to use
the lifo method for costing
inventory.© M. VAZQUEZ/AFP/GETTY IMAGES