You have choices when it comes to reporting inventory costs. One popular technique — the last-in, first-out (LIFO) method — assumes that merchandise is sold in the reverse order it was acquired or produced. That is, it allocates the most recent costs to the cost of sales. Although this method is often preferred for tax purposes, internal accounting personnel may be hesitant to use it for various reasons.
Last-in, First-out Inventory Costing Method: Overview and Benefits
Assuming your inventory costs generally increase over time, LIFO offers a definite tax advantage over other inventory reporting methods. By allocating the most recent — and, therefore, higher — costs first, LIFO maximizes your cost of goods sold, which minimizes your taxable income.
In contrast, the first-in, first-out (FIFO) method assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices.
Financial Reporting Challenges
Before you jump headfirst into using LIFO, it’s important to recognize that it’s not permitted under International Financial Reporting Standards (IFRS). The approach also involves sophisticated record keeping and calculations.
For example, the “LIFO conformity rule” generally requires you to use the same inventory accounting method for tax and financial statement purposes. Switching to LIFO may reduce your tax bill, but it could also depress your current earnings and reduce the value of inventories on your balance sheet, thus giving the appearance of a weaker financial position.
LIFO also can create a problem if your inventory levels are declining. As higher inventory costs are used up, you’ll need to start dipping into lower-cost “layers” of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed you to defer which is referred to as LIFO liquidation.
LIFO Recapture Amount
Moreover, if a C corporation elects S corporation status, the business must include a “LIFO recapture amount” in income for the C corporation’s last tax year. The recapture amount is the excess of your inventory’s value using FIFO over its value using LIFO. Fortunately, you can spread out the tax payments over four years in equal, interest-free installments.
Measuring Changes in Inventory Costs
One of the biggest challenges in using LIFO is the need to measure changes in inventory costs. If you currently use LIFO, you may be able to enjoy additional savings by electing to use the inventory price index computation method. It may enable you to reduce administrative costs — and it might even generate greater tax benefits — if you rely on government indexes to calculate LIFO values rather than developing an internal index.
Finding the Right Method for Your Company
If you’re interested in learning more about the issues and challenges retailers using the last-in, first-out method may face, check out our article: What Retailers Using Last In First Out (LIFO) Need to Know. It provides a comprehensive overview of what retailers need to know when using LIFO, which can help you decide whether it’s the proper inventory reporting method for your business. For any other questions, please don’t hesitate to contact us.