The effect of last-in, first-out (LIFO) is to value inventory at the earliest prices and to include the cost of the most recently purchased goods in the cost of goods sold. This assumption, of course, does not agree with the actual physical movement of goods in most businesses. There is, however, a strong logical argument to support LIFO. A certain size of inventory is necessary in a going concern—when inventory is sold, it must be replaced with more goods. The supporters of LIFO reason that the fairest determination of income occurs if the current costs of merchandise are matched against current sales prices, regardless of which physical units of merchandise are sold. When prices are moving either up or down, the cost of goods sold will, under LIFO, show costs closer to the price level at the time the goods are sold. Thus, the last-in, first-out (LIFO) method tends to show a smaller net income during inflationary times and a larger net income during deflationary times than other methods of inventory valuation. The peaks and valleys of the business cycle tend to be smoothed out.
An argument can also be made against last-in, first-out (LIFO). Because the inventory valuation on the balance sheet reflects earlier prices, it often gives an unrealistic picture of the inventory’s current value. Balance sheet measures like working capital and current ratio may be distorted and must be interpreted carefully.
The difference between FIFO and LIFO can be described by examining the cost of goods available for sale. Recall that the cost of goods available for sale equals the cost of beginning inventory plus the cost of the year’s purchases. By year end, each inventory item either will have been sold or will remain on hand. FIFO assumes that the cost of goods sold consists of the costs of the beginning inventory and the earliest purchases, and that the ending inventory is comprised of the more recent costs. In contrast, LIFO assumes that the cost of goods sold consists of the most recent costs and that the costs of beginning inventory and the earliest purchases are included in ending inventory.
In inventory valuation, the flow of costs—and hence income determination—is more important than the physical movement of goods and balance sheet valuation.