In April 2021, one year into the COVID-19 global pandemic, the US economy is flush with cash and investors/business owners are looking to deploy resources and grow their businesses, and demand for product input is growing. At the same time, the economy faces a major supply chain disruption largely due to a contraction in the labor market.
With demand high and supply lagging, it’s no surprise that inflation is on the rise. Beginning in April 2021 and including the nine months that followed, the US has experienced the highest sustained average inflation increase since the early 1980s. At the end of 2021, many manufacturers saw inventory volume increases along with product cost increases. It may be time to consider a conversion to the Last In, First Out (LIFO) Inventory Method.
What is the LIFO Inventory Method?
Last In, First Out (LIFO) is an accounting method used to capture the cost of inventory under the theoretical assumption that the last item purchased is the first item sold. Imagine you are having family over for dinner and you are stacking plates (only in an accounting article are we considering dinner plates inventory), the last plate placed on top of the stack will be the first plate used. In other words, the LAST plate IN the stack, will be the FIRST plate OUT of the stack.
It is important to note that LIFO is simply an accounting method, and it does NOT impact the physical flow of inventory. Often companies will continue to use the FIFO method operationally and apply a year-end adjustment to record the calculated “LIFO reserve” or a reduction to inventory cost added to Cost of Goods Sold. Adopting the LIFO method does not necessarily change a company’s day-to-day operations or impact how they record inventory in their ERP system.
What is the Benefit of LIFO?
In a period of increasing inflation, the more recently purchased items are bought at a higher cost. Under the LIFO method, the increasing prices of inventory can be deducted against current sales creating what can be a substantial tax deferral strategy. When considering a tax deferral strategy, it is critical to consider two concepts:
- First, in the initial year the change is elected it will create a substantial tax reduction, this is often viewed as an “interest-free loan” from the government. In the case of the LIFO method strategy, if inflation continues, the amount of the interest-free loan increases each year.
- Second, the interest-free loan will come due at some point in the future. If product costs decline or if inventory is liquidated, the tax deferral created by the LIFO method will be recognized and the related tax paid.
- However, during the period of the interest-free loan the business can deploy the cash saved to keep line of credit borrowings down or invest in new equipment to further grow the business. Under the principle of “time-value of money” the length and amount of the “interest-free loan” can have substantial value.
For a quick illustration, let’s assume we have a producer of iron and steel products with $5M of inventory at year-end and a similar amount of inventory at the end of the prior period (FIFO). Applying the Producer’s Price Index (PPI), which indicates a 90% price inflation on this product, to the prescribed methodology for calculating the LIFO reserve under the Link-Chain method, the estimated LIFO Reserve for this company would be $2.375M. Then apply a combined estimated tax rate of 35% (Federal and State) and the interest-free loan equates to $830,000.
When and how do you make the LIFO election?
An election can be made to adopt LIFO at any point up to the tax return’s extended due date. For the 2021 calendar year-end entities, the election can be made on an originally filed or amended return filed before September 15, 2022.
The LIFO accounting method change election is different from other types of accounting method changes which typically require the Form 3115 to be filed. The LIFO method election is made on Form 970 and carries its own set of rules unique to this election.
Other Considerations Regarding LIFO
Under the IRS conformity requirement, a business using LIFO for tax purposes must also use LIFO for financial reporting purposes. The conformity requirement should be strictly followed, or the “interest-free loan” discussed earlier is put at risk. The financial reporting requirement should be carefully considered by management and may necessitate a discussion with lenders to evaluate the impact of financial reporting and covenant restrictions. Experienced lenders should understand the impact of the LIFO adjustment and be able to adjust accordingly, but a proactive discussion is recommended.
International financial reporting standards (IFRS) does not recognize the LIFO method, therefore companies required to prepare financial statements in accordance with IFRS standards are ineligible to utilize the LIFO method
Summary of LIFO
- In periods of high inflation, electing the LIFO method can create a tax deferral opportunity. Tax deferral strategies are often viewed as an interest-free loan.
- Electing the LIFO method is an accounting method change and does not impact the physical flow of inventory.
- The election can be made retroactively for a tax period, up to the extended due date of that year’s tax return.
- Conformity requirement – if the LIFO election is made for tax, it must also be used for financial reporting.
- Exception: taxpayers may use a non-LIFO inventory method for internal management use only, so long as these reports are not provided to shareholders or other equity holders.
- A pro-active conversation with lenders is highly recommended to discuss the impact on financial statements and covenant restrictions.
Contact your local Blue & Co., LLC consultant to evaluate whether the LIFO method can help you capture the benefit of an “interest-free loan”.