Common LIFO Misconceptions
- LIFO benefits will be minimal for companies with frequent inventory turnover – Inventory turnover rate is irrelevant; only the FIFO inventory balance (current-year cost) and inflation (deflation) rate impact the amount of LIFO expense.
- Low inflation rates will not produce significant LIFO benefits – Consistent positive inflation can produce sizable LIFO benefits for companies with significant inventories. Sizable LIFO benefits are also possible for companies with small inventories for which there is consistently high inflation.
- Book and Tax LIFO methods need to be consistent – This was true until the late 1970s but the IRS Regs. LIFO “conformity rule” was changed at that time to require only the conformity of the LIFO election scope (goods on LIFO). The Regs. specifically permit different book and tax LIFO methods.
- Valuation (Lower-of-Cost-or-Market) reserves provide as much or more benefit than LIFO – If this seems to be true for a company, the reserving method would not likely pass muster with the IRS. Even if a LCM reserve may exceed the first year LIFO reserve, the LIFO reserve will grow with continued inflation regardless of FIFO value increases and this is not true of LCM reserves. LCM reserves must be taken into income when LIFO is adopted as a Section 481(a) adjustment but this is spread over 3 years.
- LIFO reserve increases require increasing FIFO inventory balances – Unless FIFO values decrease significantly, the amount of inflation is a far more important determinant of LIFO expense than FIFO values and significant LIFO reserve increases are possible even with sizable FIFO inventory decreases.
LIFO Examples of Correlation Between FIFO Balance Changes and LIFO Expense/Income Amounts:
The examples make assumptions & provide results as follows:
Assumption: FIFO Inventory increases at the same rate as inflation starting at $1,000,000 in the base year.
Results: LIFO expense will increase slightly more each year from $20,000 in 2002 to $21,224 in 2005.
Assumption: Same as example 1 except that inventory doubles to $2,122,416 in 2005.
Results: Same LIFO expense amount for all years. The 2005 LIFO expense amount is the same despite the 2005 FIFO balance doubling. This is because the LIFO expense is not affected by increased current year FIFO balances as long as the FIFO amount is greater equal to or greater than the prior year FIFO inflated by the current year inflation. This increased FIFO however, will affect the next year LIFO calculation.
Assumption: Same as example 1 except that inventory decreases to $1,000,000 in 2004 and $900,000 in 2005.
Results: There is LIFO expense for both these years or $17,278 and $10,861 for 2004 and 2005, respectively. This shows that LIFO expense can result from decrease FIFO balances.
Assumption: Same as example 3 except that inventory decreases to $750,000 in 2005.
Results: There is $562 of LIFO income in 2005. This is because the LIFO layer erosion effect is greater than the inflation effect.