Year-End Opportunity: Leveraging LIFO To Fight Inflation

Navigating inflation has been a major challenge for many businesses over the past two years. While rising prices cannot always be controlled, there is a tax strategy that may help mitigate the impacts – but time is running out.

The LIFO Method

The last-in first-out, or LIFO, method of accounting for inventory treats the most recently purchased or produced item as the first unit sold. In periods of rising prices, this increases a company’s cost of goods sold and reduces income. The following example demonstrates and compares the accounting result between LIFO and the more commonly used first-in, first-out (FIFO) method.

ABC Co. sold 1,000 widgets during the month of December for $150 per widget. The widgets sold by the company were purchased at a price of $90 per widget in January and $100 per widget in November.

Even though the economics of the transactions are identical, using LIFO results in a lower amount of income – and therefore tax due. LIFO can provide a significant benefit to manufacturers, distributors, and retailers that invest significant amounts in maintaining inventory.

LIFO Considerations

The tax law requires that taxpayers use LIFO for both their tax return and their financial statements. This is referred to as the conformity rule. While seemingly simple, there are traps for the unwary. The conformity rule applies not only to a company’s formal financial statements (e.g., audit, reviewed, etc.) but also applies to all financials provided to external parties (banks, customers, etc.). Additionally, the conformity rule can be blown even without issuing a full year financial statement if interim financials were issued without a LIFO reserve that could be combined to create the entire year. Thus, if a company is considering adopting LIFO, it should include a LIFO reserve in its December financials, any previously unreported periods, and subsequent periods.

Is LIFO Worth It?

While the requirement to use LIFO for both “book” and tax records may be a deterrent to some companies, it offers potentially significant tax deferrals and is worth consideration. The size of the benefit is primarily driven by the amount of inventory and the level to which prices are rising for the inventory.

Adopting LIFO in a year of 5% inflation is beneficial but not as beneficial as 10%. However, a single year should not influence the decision too heavily. Assuming inventory continues to be built, the benefit of LIFO continues to build and grow as inflation continues to increase.  It may not be beneficial to adopt LIFO in a year of unusually high prices when deflation is expected in subsequent years. With the unprecedented supply chain issues in recent years, it will be important to model the potential impact of adopting LIFO and consider “what if” scenarios for changes in future years.

Act Now

The decision to adopt LIFO should be done thoroughly and carefully, but don’t delay. Draft financials are commonly issued shortly after year-end, which means analysis and booking of reserves should happen prior to year-end. Discuss the option with your KSM advisor – or fill out this form – as soon as possible to ensure maximization of the benefit and compliance with the conformity requirement.