The last time there was this much discussion about LIFO inventory it was the 1980’s and the country had experienced a period of high inflation in the 1970’s. Now that we have been experiencing similar high inflation, the topic of LIFO inventory is resurfacing.
When inflation is low, effects of changing inventory valuation are less impactful. In a period of high inflation, the decision to convert to the LIFO inventory valuation method could result in material tax savings.
What is the LIFO inventory method?
LIFO stands for “Last In First Out” inventory valuation methodology. Using this method of valuing inventory, the most recent purchases of inventory are matched against the current period’s sales. This would be expected to reduce profits, and therefore reduce taxes, during a period of rising prices – when compared with FIFI inventory valuation.
FIFO stands for “First In First Out”. In this method of valuing inventory, the oldest inventory is assumed to be sold first.
Is LIFO an allowed inventory method?
The rules surrounding LIFO inventory are complicated. A business considering using LIFO should discuss the pros and cons with their tax advisors and their auditors. The following link takes you to the IRS summary information related to LIFO. It is a short read and covers important topics when considering switching to LIFO.
A few things to consider:
If a company elects to use LIFO, LIFO must be used for tax and book financial reporting. It must also be used for credit applications and reporting to shareholders, owners, beneficiaries, etc.
If a company adopts the Internation Financial Reporting Standards (IFRS), LIFO must be terminated as IFRS does not allow LIFO.
The IRS Commissioner must approve a change away from LIFO, once LIFO is elected.
Complicated detailed record keeping is required under the Internal Revenue Code and Treasury Regulations. LIFO layers and SKU based record keeping are some of the issues to review and discuss with outside accountants, tax advisors, and internal inventory system experts. Lack of compliance with the record keeping requirements may cause the IRS to terminate a company’s ability to use the LIFO valuation method.
Once LIFO is terminated, a company may not elect to return to LIFO for at least five years, unless there are special circumstances.
With all these considerations, why is LIFO interesting?
Let’s work through an example of the impact of LIFO versus FIFO inventory valuation. In this example a company begins the year with 10,000 units at $100 per unit in inventory. During the year 50,000 units are purchased at $120 per unit. After sales of 40,000 units the ending inventory is 20,000 units. The decision between LIFO and FIFO impacts the value of the ending inventory, and therefore, the cost of goods sold for the period.
First let’s look at FIFO. The 20,000 of remaining units on hand would be valued at the most recent purchase price of $120 per unit. This valuation flows through the income statement to show $4.6 million of costs of goods sold, and $3.4 million of gross margin based on a $200 per unit sale price. The company would report a gross profit of 42.5%.
The cash outflow for inventory purchases during the year would be $6 million.
Now let’s consider LIFO in the same situation. The 40,000 units sold during the year would be valued at the most recent purchase price for inventory of $120 per unit. The 20,000 units on hand at the end of the year would be valued at a combination of 10,000 units at the recent purchase price of $120 per unit and 10,000 units at the beginning of the year value of $100 per unit. The company would report $4.8 million of cost of goods sold and $3.2 million gross margin, using the same $200 per unit sale price. The company would report a 40.0% gross margin.
The cash outflow for inventory during the year would be $6 million.
What is the impact of FIFO versus LIFO for this company?
LIFO would result in $200,000 less inventory value on hand, which at a 60% ABL advance rate would result in lower availability of $120,000.
LIFO would result in $1.2 million less gross profit, which at a 21% Federal tax rate would result in tax savings of $252,000.
The actual cash spend for inventory remains the same at $6 million.
Even with the lower availability, the net positive impact of LIFO could be $132,000 of additional cash on hand.
The company would need to determine the additional accounting fees and record keeping costs to determine if those costs outweigh the impact of the additional cash on hand.
When considering the pros and cons of LIFO inventory valuation, the ongoing costs should be considered, as well as the impact of using LIFO during a period of stable or declining prices. Moving to adopt a new inventory method may seem wise in the short term but given the special requirements around LIFO and changing inventory valuation methods, it is important to consider outcomes under a multiple number of scenarios.
Does LIFO complicate financial analysis?
The short answer is yes. Decision makers relying on financial information will need to understand the inventory valuation method used and how future performance may be impacted.
For example, if inventory is expected to be reduced, LIFO layers may be eroded which will apply older period costs against current sale prices. This would increase profits therefore increase tax liabilities.
The LIFO reserve is the difference between FIFO and LIFO inventory valuation and is reported as an inventory contra account on the balance sheet. In the example used, this LIFO reserve would be the $200,000 difference between FIFO and LIFO. Some consider this reserve to be an interest free loan to the business, and a component of a way to quantify potential incremental tax expense if inventory layers are reduced.
During periods of high inflation, companies look for ways to reduce cash outflows such as the tax liability. LIFO can provide relief. However, there are complications and costs that need to be considered.
Typically, companies report inhouse interim financial information using FIFO and then the auditors or outside advisors calculate the LIFO impact. Users of the interim financial statements need to be aware of the possibility of the year-end adjustments.
Inventory is an important part of the working capital analysis of a company. Consumers of financial statements need to be careful to understand accounting methods and their impact on collateral values, future performance, and financial statement reporting.
J. Tim Pruban
President, email: t.pruban@focusmg.com | cell (813) 918.7488
Juanita Schwartzkopf
Sr Managing Director, email j.schwartzkopf@focusmg.com | cell (520) 203.2926
Joe Karel
Managing Director, email j.karel@focusmg.com | cell (312) 307.1541
John Socarraz
Managing Director, email j.socarraz@focusmg.com | cell (305) 992.5805