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Optimize Your Inventory Valuation
LIFO is an acronym for Last-In, First-Out and it describes a method of accounting based on the assumption that the newest inventory purchases are sold before earlier inventory purchases. Under this approach, the most recently acquired or produced items are the first to pass through cost of goods sold. In other words, the most recent inventory costs are matched against current revenues on the income statement, while the older costs remain on the balance sheet.
This method becomes particularly significant during periods of inflation. When prices are rising, using LIFO typically results in higher cost of goods sold and lower profits, because the newest inventory, which is sold first, is more expensive. As a result, it can reduce a company’s taxable income and therefore, its tax liability. However, it can also result in an inventory valuation on the balance sheet that is out of sync with the current net realizable value.
FIFO is an acronym for First In, First Out which is the direct opposite inventory method to LIFO as it assumes the first inventory purchased is the first sold. During inflation, the FIFO accounting approach will lead to higher values on ending inventory as opposed to the LIFO approach with more cost capitalization on inventory but lower tax savings benefits.
This makes LIFO a more advantageous method, particularly as prices rise, because it places a lower value on remaining inventory which equals a higher Cost of Goods Sold. That can have a direct effect on reducing a company’s taxable income and the amount of tax owed for the year.
The LIFO reserve is a way for companies (and financial statement users) to bridge the gap between these two inventory methods. If a company reports its inventory using the LIFO method, it might also provide the LIFO reserve figure, which can be added to the reported LIFO inventory to estimate what the inventory would have been under the FIFO method. This can be useful for analysts who want to compare the financial statements of two companies that use different inventory accounting methods.
To better illustrate how LIFO works, the following example demonstrates how this method can eliminate the downside of inflation from the inventory of your company:
Company X purchases and sells just one single product. At the start of the year, the cost to purchase the product is $10.00. The product is then purchased and sold multiple times over the course of the year with a year-end purchase cost of $12.00.
If Company X had just one of these products in the start-of-year and end-of-year inventory, LIFO would yield a tax benefit of $2.00 which represents the difference in the FIFO value ($12) and LIFO value ($10). By using LIFO, Company X increased its Cost-of-Goods-Sold (COGS) by $2 . This also reduces their tax liability. Simply put – valuing the product in the year-end inventory at LIFO offers an advantage when compared to the FIFO value. For accounting purposes, it appears that Company X has the older, earlier purchased product in inventory and not the newer, more expensive product.
Taking the next year into consideration under the same conditions but with a last purchase price of $15.00, the cumulative LIFO benefit for Company X would be $5.00 which breaks down to a $15.00 FIFO value contrasted against the LIFO value of $10.00. This would result in a P&L for the current year of $3.00 – the difference between the cumulative LIFO benefits of this and the previous year.
The LIFO method is the beneficial accounting approach for enjoying tax benefits as prices on inventory rise from year to year.
There are three different methods to consider that offer advantages to companies in certain industries. One method may be adopted as the standard or a business may elect to switch out their preferred method after the minimum number of years has elapsed:
Through a review of their internal price experience, a company can identify the LIFO methods most suitable for their financial and tax reporting needs. There are a wide variety of internal LIFO methods that are available. The scope of the LIFO election and the precise methodology for calculating the LIFO index should be determined based on what works best for the client. The primary criterion for identifying a method should be to align with the applicable Treasury regulations.
For automotive dealerships, the IRS has provided the Alternative LIFO Method for new vehicles and the Used Vehicle Alternative LIFO Method. A simplified version of an internal LIFO calculation method, the ALM and the UVALM are generally beneficial for dealerships.
Originally developed by the IRS in the 1980s, this method uses monthly indexes from the Bureau of Labor Statistics to measure their inventory’s inflation. The BLS categories reflect a domestic rate of inflation and do not include offshore manufacturing or overseas purchases. The BLS indexes generally display a higher rate of inflation and, thus, a greater benefit from LIFO.
In order to use LIFO, a company must formally elect to do so through filing Form 970 – Application to Use LIFO Inventory Method. Should a company wish to make any changes to the accounting method, they must do so on Form 3115 – Application for Change in Accounting Method.
The IRS stipulates specific requirements for a business to use the Last-In, First-Out method for inventory accounting. They are:
Once a company chooses to use LIFO, it must continue to use it in all subsequent years. The IRS allows a company to switch its inventory accounting method to LIFO, but once it makes this change, it must receive IRS approval to change it again.
The "LIFO conformity rule" states that if a company uses the LIFO method for tax reporting, it must also use LIFO for financial reporting. This rule prevents companies from using one method for tax purposes and another for reporting profits to shareholders.
Detailed inventory records are required when using the LIFO method. A company must be able to track the specific costs of each item of inventory.
Businesses should not value LIFO inventory at more than its current-market cost when reporting taxable income.
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LIFO stands for “Last-In, First-Out.” It’s an inventory cost flow assumption and identification method that assumes the most recently purchased items are sold first.
In order to use LIFO, a company must formally elect to do so through filing Form 970 – Application to Use LIFO Inventory Method. Should a company wish to make any changes to the accounting method, they must do so on Form 3115 – Application for Change in Accounting Method. The company is also required to use LIFO for financial reporting purposes, the “LIFO conformity requirement.”
LIFO can potentially reduce income taxes during periods of inflation by lowering reported cost of goods sold (COGS), leading to higher taxable income. It can also simplify record-keeping for certain industries.
