Tired of hearing about inflation? Brace yourself: despite federal attempts to tamp it down, odds are we’ll be dealing with it a little while longer. According to the Bureau of Labor Statistics, inflation for 2022 hit 8.3% in August, its highest rate in 40 years. Supply chain issues, a strong labor market, rising energy prices, the war in Ukraine, and the lingering effects of the pandemic are some of the primary contributing factors.
In an environment like this, companies will naturally want to look for ways they can save money. One potential opportunity is switching to the last-in, last-out (LIFO) inventory accounting method. Under the right circumstances, it allows companies to save money on taxes (and dividends, when applicable) by lowering their net income.
Permitted under the U.S. Generally Accepted Accounting Principles (GAAP), but not under International Financial Reporting Standards (IFRS), LIFO isn’t right for all situations. However, it’s worth researching its potential impact to see if it’s a smart choice for your business.
What is LIFO?
The three most commonly used inventory accounting methods used in the US are first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted average.
FIFO, which is used most often, assumes that a company’s oldest unit of inventory will be sold first and uses the cost of that inventory as a basis for determining profit. In most cases, FIFO is aligned with the physical flow of inventory, offering businesses an accurate picture of true inventory costs. The primary drawback to FIFO is that when inflation is high, current inventory costs more than older inventory costs. This means higher profits—along with a bigger tax bill—when the older inventory is sold first.
Last-In, First-Out (LIFO), on the other hand, assumes that the most recent unit of inventory is sold first. When inflation is climbing rapidly, newer inventory generally costs more than older inventory. By assuming that new inventory is sold first, the LIFO method reduces the amount of net profit and with it, the company’s tax obligation.
Finally, the weighted average method averages the cost of inventory over a given period of time and uses that number as the basis for determining profit.
Whichever method a company uses when it files taxes, it must use the same method when reporting financial results to shareholders.
Benefits of the LIFO Accounting Method
When inflation is high, and the cost of goods sold (COGS) is increasing, LIFO allows a company to sell its most recent (and most expensive) inventory first. This lowers the company’s net income, generating a tax savings and, when applicable, lower dividends, which means improved cashflow for the company.
This lower tax liability will continue as long as inflation rises, but if prices decline or if inventory is liquidated, the company may see higher net profits and consequently, a higher tax liability.
The LIFO method also offers a more accurate view of current margins—and a more accurate income statement—because it’s based on the most recent COGS.
In most cases, the switch from one method to the other does not impact the actual physical flow of inventory or a company’s day-to-day operations. In fact, a company can defer the decision to elect LIFO until its tax return’s extended due date, by which time it should easily be able to see how much benefit LIFO will confer.
Drawbacks of the LIFO Accounting Method
Using the LIFO method has its downsides, however.
Deciding to use LIFO isn’t simply a matter of switching to a new method of record keeping. Companies must complete and file IRS Form 970, Application to Use LIFO Inventory Method, along with their annual tax returns. Reverting back to the FIFO method at a later date will require IRS approval.
Companies should also be sure to proactively discuss the switch to LIFO with lenders, as it could affect their debt-to-equity ratios and potentially violate debt agreements.
The “conformity rule” states that whichever inventory accounting method a company uses for tax purposes, it must use the same one for financial reporting. One of the advantages of the FIFO method is that it raises net income and with it, earnings per share, thus keeping shareholders happy. LIFO, on the other hand, depresses net income and earnings per share. While the ultimate tax savings may be worth it, shareholders are likely to be disappointed in the short term.
Finally, the US and Japan are the only countries that permit taxpayers to use LIFO, which is not recognized under the international financial reporting standards (IFRS). Using LIFO could cause conformity issues for US companies that are subsidiaries of or parent companies to foreign entities in countries that have adopted IFRS.
Does LIFO Make Sense for Your Business?
Theoretically, any company that is facing rising inventory prices can benefit from LIFO accounting, but of course, reality is somewhat more complicated.
As mentioned above, the IFRS prohibits LIFO because it may distort a company’s profitability and financial statements. Companies required to prepare financial statements in accordance with IFRS standards are generally ineligible to use LIFO.
Because of the complexities of LIFO, it can be trickier to accurately record costs and expenses. In particular, large businesses with multiple operations that use different inventory management systems may struggle with this. And finally, because LIFO depresses your net income, it may look to shareholders that you are doing less well financially than you are.
LIFO has the potential to save some businesses substantial amounts of money, but it certainly isn’t the right choice for all. Those that are considering the switch should conduct a cost-benefit analysis that considers the benefits, complexities, costs, and compliance requirements.
We strongly suggest talking with us to determine which accounting method makes the most sense for your business and how to maximize its benefits.