Stimulate business growth and create cash from idle inventory.
What is LIFO Accounting?
LIFO stands for Last-In, First-Out. It is an accounting method that assumes the inventory most recently purchased is sold first. In periods of inflation, this means the highest priced items will be sold and removed, leaving the earlier, lower priced items in the ending inventory. The LIFO accounting method is strictly a cost flow accounting method and does not impact the actual flow of goods in your business. You do not have to keep old stock on hand to benefit from LIFO.
What is the difference between LIFO vs. FIFO?
FIFO stands for First-In, First-Out. Essentially, it follows the exact opposite inventory method from LIFO by assuming the items you purchased first are the first items sold. In periods of increasing prices, the FIFO inventory method will yield a higher ending inventory value compared to LIFO. This results in more costs capitalized to inventory and less tax savings.
What are the advantages of LIFO?
When prices are increasing, the LIFO inventory method will value ending inventory lower than other inventory methods such as FIFO or average cost. Lower ending inventory value means higher Cost of Goods Sold which reduces taxable income and lowers the amount of income tax your business pays in any given year.
Below is a simple example that illustrates the LIFO concept and how LIFO removes the detrimental effects of inflation from a company’s inventory:
Retailer XYZ buys and sells only one item. At the beginning of the year the item cost $10.00 to purchase. The item was purchased and sold many times throughout the year with the final purchase price at year-end being $12.00.
Assuming Retailer XYZ had only one of the items in both year beginning and year ending inventory, the LIFO method would create a tax benefit of $2.00 (the difference between the company’s FIFO value of $12.00 and LIFO value of $10.00). This would be an additional deduction for the company, creating cash in the form of reduced tax liability.
The result is achieved by valuing the one item in ending inventory at its earlier, last-in, first-out (LIFO), value as compared to its higher, first-in, first-out (FIFO), value.
From an accounting standpoint, the company is deemed to have the older, earlier purchased inventory item on hand, not the more recent, higher priced item.
Carrying this example forward to the next year. Assuming the same fact pattern and a last purchase price of $15.00, the cumulative LIFO benefit would be $5.00 ($15.00 FIFO value compared to the $10.00 LIFO value) with the current year P&L impact being $3.00 (difference between the current year cumulative LIFO benefit and the prior year cumulative LIFO benefit).
You can see that over time, as inventory prices naturally rise, the LIFO inventory method continues to yield ongoing tax benefits.
What is a LIFO Reserve?
A LIFO Reserve is the difference in inventory value between the LIFO inventory method and FIFO inventory method. It represents the cumulative tax benefit of being on LIFO. Many companies use the FIFO method to monitor their inventory, but use the LIFO method to report income on financial statements and for tax preparation. During periods of inflation, the LIFO Reserve will increase year over year.
Source Advisors helps companies of all sizes across a wide range of industries adopt one of three LIFO methods or convert from one method to another:
Internal LIFO Calculation Method
Using an internal calculation based on actual inventory items purchased, a company can measure inflation by comparing the cost of items purchased at the beginning of the year to similar items purchased at the end of the year. Companies with astute purchasing strategies might be able to drive down costs among specific categories that might not be reflected using an aggregated method.
Inventory Price Index Computation (IPIC) Method
IPIC is an IRS-preferred method that uses monthly indices published by the Bureau of Labor Statistics (BLS) to measure annual inflation in a company’s inventory. The BLS categories are a domestic measure of inflation and do not take into account offshore manufacturing or low-cost overseas purchasing. While aggregated categories might not be an exact representation of the actual inventory mix, the BLS indices nearly always show higher inflation, resulting in a greater LIFO benefit. Additionally, companies that convert from an internal calculation method to IPIC are given audit protection for the previous LIFO accounting method.
Due to the unique nature of its inventory, the automotive industry has a specific LIFO method of its own. This method compares the base model cost of vehicles year over year by manufacturer and brand for both new and used vehicles.
Like other accounting methods, a company must formally adopt the LIFO inventory method. Initial elections are made by filing Form 970, Application to Use LIFO Inventory Method. Changes within LIFO are made by filing Form 3115, Application for Change in Accounting Method.
Once the LIFO method is adopted it must be used for a minimum of five years before a company may automatically make a change to another inventory method. Additionally, the LIFO accounting method must be used for both financial (book) and tax filing and reporting purposes, although it is worth noting a company is not required to have the same LIFO method for both book and tax.
Who Can Benefit from LIFO?
Taxpayers with inventory in any industry (manufacturing, retail, distribution) are eligible to adopt and receive a benefit using LIFO.
LIFO Case Studies
Source Advisors has performed LIFO accounting services for 37 years. Recent LIFO implementations include: