The Last-in, First-Out (LIFO) accounting method is an inventory cost flow assumption for financial and tax reporting purposes. Under this approach, the cost of the most recently acquired inventory items are assumed to be the first ones sold or used. This means that the cost of goods sold (COGS) is calculated using the most recent inventory costs, leaving older inventory costs in the ending inventory balance. There are several advantages to this accounting method which can be highly beneficial for tax purposes especially during periods of inflation.
As LIFO is considered a method of accounting, a taxpayer has a variety of options when applying the methodology. Two options available to taxpayers include the Inventory Price Index Computation (IPIC) and Internal methods. These methods are deemed to be Dollar-Value LIFO methods. The Dollar-Value method of valuing LIFO inventories is determined by using “base-year” costs expressed in total dollars, as opposed to using the quantity and price of specific goods as the unit of measure. Under the Dollar-Value method, a taxpayer would group goods contained in its inventory into a pool(s). After grouping goods into their applicable pool(s), an overall price index is used for the pool(s) to determine the changes in inventory cost.
In the below example, a taxpayer manufacturers clothing (skirts and shirts).
There are a wide variety of Internal LIFO methods available to a taxpayer. The precise methodology used in calculating the LIFO index will depend upon the taxpayer’s specific circumstances. The primary criteria in identifying an appropriate method should be to align with the applicable Treasury regulations.
By leveraging the benefits of LIFO, such as lower taxable income during periods of inflation, businesses can reduce their tax liabilities and improve their cash flow. With Source Advisors as a trusted partner, businesses can confidently navigate the complexities of LIFO accounting and unlock the full potential of their inventory assets.
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