Inflation has been on the rise for more than a year, as the COVID-19 crisis fuels greater consumer demand and supply chain constraints. According to the Labor Department, consumer prices had increased 7.5 percent by January 2022 in a year-over-year comparison, and producer prices increased 9.7 percent in the same period.
Inflation affects every sector of the manufacturing & distribution industry. While the causes of inflation are beyond the owner’s control, business strategies and proactive planning can help mitigate the financial impact on the business.
One particularly effective strategy in this economic climate is the LIFO accounting method. Short for “last in, first out,” this inventory valuation method assumes that the most recent products (produced or purchased at inflated price points) are sold first (before products produced or purchased at lower price points). The price paid for the more recent products is used in the cost of goods sold (COGS) calculation, producing substantial tax savings.
Benefits of LIFO
The most significant advantage of adopting LIFO is the cash flow generated through income tax savings. When inflation increases the value of inventory items sold, LIFO allows those higher costs to be reported on the current year’s tax return, thereby increasing the COGS amount and reducing taxable income.
Another benefit of LIFO is the ability to match current costs with current revenue. Many financial analysts have suggested that this produces a better “quality of earnings” during an inflationary period. In addition, it produces a conservative balance sheet valuation since inventory is valued at the lower LIFO cost rather than the higher FIFO (first in, first out) cost.
LIFO Considerations
Changing to the LIFO method will add complexity to bookkeeping procedures, inventory valuations and compliance procedures. One of the most significant conformity requirements under LIFO is reporting primary financial earnings to shareholders, creditors and other stakeholders when LIFO has been adopted for tax purposes.
When used during inflationary periods, LIFO typically results in a conservative inventory amount on the balance sheet because ending inventory reflects older and generally lower costs. As a result, shareholders’ equity is more conservatively stated than if FIFO had been used. If the company has a relatively high level of borrowing, adopting LIFO could adversely affect the debt to equity and potentially violate debt agreement covenants.
The adoption of LIFO might also result in higher annual costs of computing inventory, since records will most likely need to be maintained on both a FIFO and LIFO basis. These additional clerical costs should be weighed against the expected tax savings when considering LIFO. The Inventory Price Index Computation (IPIC), which is a simplified LIFO calculation using general published indexes, can be considered to help reduce clerical costs.
Keep in mind that LIFO is allowed in the U.S. only and is governed by GAAP (Generally Accepted Accounting Principles) rules. The LIFO method must be elected by completing and filing Form 970, Application to Use LIFO Inventory Method, with your company’s annual tax return. Reverting back to the FIFO method after adopting LIFO will require IRS approval.
Conclusion
LIFO can be an excellent tool to generate tax savings and cash flow. In fact, analysts and other sophisticated readers of financial statements frequently question why companies do not use it more often. But given its complexities, costs and compliance requirements, each business owner needs to consider their own unique set of facts and circumstances before deciding if LIFO is the right strategy for their company. Careful planning and consulting with your CPA are essential to choosing the right accounting method, customizing it to your business and maximizing its benefits.
For more information or to determine if LIFO is a good choice for your business, please contact your Grassi advisor or Michael Violano, Partner.
