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    How LIFO Accounting Works

    LIFO is an acronym for Last In, First Out and it describes a method of accounting based on the supposition that newly purchased inventory is sold ahead of that which was purchased earlier. During periods of rising inflation the theory is that higher priced inventory will be sold and distributed while the earlier and lower priced products will be part of the ending inventory.

    The LIFO method has no bearing on the actual distribution of product, this is only a cost flow method for accounting and a company is not required to retain old stock within inventory in order to enjoy the tax benefits.

    LIFO and FIFO

    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 are the first sold and removed. 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.

    LIFO Reserves

    A LIFO Reserve describes the contrast of inventory value between the LIFO and FIFO inventory methods and demonstrates the cumulative tax benefit of using the LIFO approach. While many businesses will employ FIFO as a means to monitor the status of inventory, it’s the LIFO approach that is most often chosen for reporting income. When inflation is rising, a company’s LIFO Reserve will increase from one year to the next.

    LIFO Example

    To better illustrate how LIFO works, the following is an example to demonstrate the ways in which 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). Therefore, Company X would be granted an additional deduction, generating cash as a reduction in 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 prices 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.

    LIFO Methods

    There are three different LIFO 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 expired:

    Automotive LIFO

    The LIFO method that offers the most advantages to companies in a certain industry is that used by the automotive industry. They even have their own method which uses a model that implements the base model cost of a motor vehicle year over year by manufacturer and brand and applies that to new and used inventory.

    Internal LIFO Calculation Method

    Through an internal company analysis of inventory purchased, the rate of inflation can be accurately assessed with a comparison of the cost of products purchased at the start of the year with those purchased at year’s end. Using this data, a company may be able to bring the cost of goods down in certain categories that may not be reflected in an aggregated method.

    Inventory Price Index Computation (IPIC) Method

    This is the method that is most favored by the IRS in that utilizes monthly indices from the Bureau of Labor Statistics as a way to gauge inflation in their inventory for the year. Keep in mind, the BLS categories reflect a domestic rate of inflation and do not include offshore manufacturing or overseas purchases. Although the categories may not be an identical reflection of inventory, the BLS indices almost always display a higher rate of inflation and, thus, a greater benefit from LIFO.

    Requirements for LIFO Accounting

    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.