How LIFO Works

Effect of Inflation on Financial Statements & Tax Return

Figure 1. 20 Year LIFO Tax Savings Example: Assuming $20M inventory balance for all periods & 3% average annual inflation rate

Figure 2. LIFO Benefit Case Study: Building Products Manufacturer

• Misconception #1: Item costs & the physical flow of goods must be tracked on a LIFO basis
  • Under the specific goods or unit LIFO submethodology, the value of ending inventory is determined by tracking item costs & the physical flow of goods on a LIFO basis.
  • Although taxpayers are allowed to use unit LIFO, the vast majority of businesses that are on LIFO use what’s called dollar-value LIFO because it avoids all the undesirable characteristics of unit LIFO.
  • Under dollar-value LIFO, the method used to determine the value of ending inventory is completely decoupled & independent from the method used to track item costs & the physical flow of goods. In other words, item costs & the physical flow of goods are tracked & valued within your accounting system under the same cost flow method used prior to going on LIFO when dollar-value is used.
  • For example, a company who used FIFO prior to adopting dollar-value LIFO would continue tracking item costs using FIFO after switching to LIFO. The same can be said for companies using average cost, weighted average cost or standard cost & subsequently adopt dollar-value LIFO.
  • This is because under dollar value LIFO, a side calculation is made at the end of the year to adjust the value of ending inventory from cost to LIFO. After this side calculation is made, a journal entry is recorded to adjust the cost of goods sold & LIFO reserve balances. Under dollar value LIFO, the only change that’s made to your accounting system after adopting LIFO is to add a contra-inventory subledger account called the LIFO reserve. This balance sheet account represents the difference between the value of inventory at cost & inventory at LIFO. It’s the vehicle for reducing the ending inventory balance, increasing cost of goods sold, reducing pre-tax income & generating tax savings from LIFO.
  • Under dollar-value LIFO, the LIFO reserve balance is never allocated at the item level, and no changes are required in terms of how item costs are valued or how the physical flow of goods are tracked.
• Misconception #2: Management forecasting & planning functions will be severely complicated by using LIFO
  • A frequent fear of management & cost accountants is that LIFO will impair their abilities to perform essential forecasting & planning functions related to purchasing decisions, sales projections & forecasted profits.
  • Under dollar-value LIFO, this misconception is proven wrong. Management & cost accountants can continue forecasting & planning their purchases, sales & profit margins using the cost flow methods that are most representative of current or projected item costs, such as FIFO, average or standard costs.
  • Under dollar-value LIFO, the effect of LIFO is never felt at the item level, so management can rest assured that key internal business decisions related to inventory will remain unaffected & be made using the same historical costing methods.
• Misconception #3: Gross margins & profit-based incentives will be negatively impacted by implementing LIFO
  • Although LIFO effects the balance sheet & income statement, many companies choose to categorize the change in the LIFO reserve as a selling, general & administrative expense on the income statement, which prevents it from effecting gross profit.
  • As a result, companies with incentives & bonuses tied to sales & profit margins can effectively avoid LIFO from affecting profit-based compensation.
  • Furthermore, companies often present financial measures such as gross margins, EBITDA & EPS showing both including & excluding LIFO on their financial statements in order to accommodate financial results to be compared to other companies that don’t use LIFO.
• Misconception #4: Internal costs must be used to measure LIFO inflation
  • Although there are legitimate reasons for not wanting to measure price changes using internal costs for LIFO calculations, this misconception ignores the fact that taxpayers are allowed to measure LIFO inflation using externally published government inflation indexes, which is often referred to as the IPIC method, which stands for Inventory Price Index Computation.
  • Under the IPIC method, Bureau of Labor Statistics Consumer or Producer Price Index inflation categories are assigned to items & represents the sole source for measuring LIFO inflation. The benefits of using government indexes include the following:
    • External indexes may result in higher inflation being measured than internal indexes because all BLS indexes are based on domestic production. For example, under the use of PPI, surveys are taken from U.S. based producers based on net domestic sales receipts, which often creates more inflation than imported goods due to the differences of domestic vs. outsourced labor & overhead costs. The result of the higher inflation measured from using external indexes is that LIFO will create more tax savings than internal indexes.
    • Also, external indexes are often less volatile than internal indexes since the BLS indexes are measured using surveys of multiple producers. Accordingly, external indexes are based on a weighted average of the net revenues submitted by survey respondents. This causes any above & below average price changes to be pooled into a single index, which insulates external indexes against extreme price changes more so than any single internally calculated inflation index.
• Misconception #5: Administrative burden & costs of LIFO will outweigh the potential tax benefits
  • For companies using dollar-value LIFO who manage their calculations in-house using Excel schedules, LIFO can be very complicated for the following reasons:
    • The Inflation calculation can be time-intensive. For manufacturers & companies with many unique goods & product lines, the exercise of calculating inflation manually within Excel can be especially complex & time-intensive.
    • The LIFO layer & reserve calculations can also be complicated & error-prone for the following reasons:
      • For one, in any given year, a totally different set of math steps are required to be used to calculate the LIFO layers & LIFO reserve. This is because the LIFO math steps required are different when there’s an increment versus when there’s a decrement.
      • Furthermore, companies with multiple LIFO pools, business units or entities have to manage multiple LIFO calculations
      • No one-size fits all Excel LIFO template or macro exists to automate the LIFO layer & reserve computations
  • Although LIFO calculations can & often are truly complicated because of the reasons just mentioned, LIFOPro’s mission is to make being on LIFO as simple as possible.
  • By outsourcing your calculation to LIFOPro, companies can maintain the tax savings of LIFO & avoid the hassle by letting LIFOPro do all the work.
  • By licensing the LIFOPro software, companies & CPA firms can minimize the amount of time & effort required to maintain LIFO calculations in-house.
  • The costs of either solution are nominal compared to the tax savings achieved from LIFO & also is a fraction of the cost of other LIFO service providers
  • As a result, companies can accumulative material long term tax savings from LIFO with a minimal amount of administrative burden

For dollar-value LIFO method users, a company will continue tracking inventory costs within their accounting database using the same method that was used prior to adopting LIFO. This means that beginning inventory, purchases, sales & cost of goods sold recorded during the reporting period continues to be valued any of the available non-LIFO methods (i.e. FIFO, average cost, earliest acquisitions etc.). Illustration 1 below provides an example of common inventory activity occurring during the course of a reporting period using FIFO or average cost:

Illustration 1. Accounting for Inventory Activity Under LIFO – Year 1 on LIFO

The LIFO reserve contra account is shown with a zero balance because this example assumes that the company will be adopting LIFO for the 2021 year end. The main consideration is to realize that companies on LIFO continue using some non-LIFO method such as FIFO or average cost to account for current period inventory activity. Once the period has been closed and all inventory related activity has been posted, the side calculation to compute the required LIFO values can now be made. Once the current year index is computed, the ending inventory balance at cost (i.e. FIFO, average cost etc.) is used along with the current period inflation index to compute the current period LIFO inventory, LIFO expense & reserve values. Using the same inventory data from Illustration 1, an example is shown below of the period end side calculation made to compute the LIFO inventory, expense & reserve balances as well as the general ledger adjusting journal entry required to account for the difference between inventory at cost & LIFO (LIFO expense is the difference in cost of goods sold between LIFO vs. cost & is the difference between the current & prior period’s LIFO reserve):

Illustration 2. LIFO Calculation & General Ledger Adjusting Journal Entry Year 1 on LIFO

Note: Above figures portrays a simplified version of a LIFO calculation & does not show the detailed math required to calculate current period inflation index, LIFO inventory & LIFO reserve/expense balances.

As shown in the calculation summary above, the LIFO inventory balance is between $2 – $3 million less than the current period end inventory balance at cost. This difference represents the LIFO expense (current – prior period LIFO reserve) & LIFO reserve balances (inventory at cost – LIFO inventory). It also represents how LIFO transfers inflationary inventory costs from the balance sheet (inventory) to the income statement (cost of goods sold). The debits and credits in the journal entry shown above represent increases to both cost of goods sold and the LIFO reserve contra inventory account. Since the LIFO reserve account is a contra inventory account, ending inventory gross of LIFO reserve represents inventory at cost & while ending inventory net of LIFO reserve represents inventory at LIFO. The cost of goods sold account is essentially the vehicle that allows for LIFO taxpayers to reduce their taxable income. Using the data from the illustrations above, the example below shows the 2021 year end balances after the LIFO general ledger adjusting journal entry has been made:

Illustration 3. Post LIFO Calculation Inventory Balances Year 1 on LIFO

As shown above in Illustration 3, the cost of goods sold account is now $2 – $3 million higher after the LIFO calculation. Aside from any other adjusting entries required after the LIFO calculation, this will be the amount used for financial reporting and tax purposes. Although the cost of goods sold account balance will be closed out after recording the closing entries, the LIFO reserve contra inventory account is a permanent account that will be carried forward into the next reporting period.

Once elected, a LIFO calculation must be made annually at year end. This allows for LIFO to be a tax savings tool that accrues benefits in perpetuity & not just a one-time deduction. Using the data from the illustrations above, the examples shown below illustrate how inventory costs will be tracked when going from the first to the second reporting period on LIFO:

Illustration 5. Accounting for Inventory Activity Under LIFO – Year 2 on LIFO

As shown above, beginning inventory, purchases, sales & cost of goods sold continue being valued at cost throughout the course of the second period on LIFO (will remain the case for all subsequent periods on LIFO). As explained earlier, the LIFO reserve contra inventory account remains in place because the beginning inventory balance net of LIFO reserve represents inventory at LIFO cost. The example below illustrates the year 2 LIFO calculation results along with the adjusting journal entries and post-LIFO calculation general ledger inventory balances:

Illustration 6. LIFO Calculation, General Ledger Adjusting Journal Entry & Account Balances – Year 2

Note: Above figures portrays a simplified version of a LIFO calculation & does not show the detailed math required to calculate current period inflation index, LIFO inventory & LIFO reserve/expense balances. Note: Above figures portrays a simplified version of a LIFO calculation & does not show the detailed math required to calculate current period inflation index, LIFO inventory & LIFO reserve/expense balances.

As shown above, the current period LIFO calculation resulted in 17% & 13% inflation for each of the two calculations that resulted in approximately $5 million & $3.7 million of LIFO expense (increase to cost of goods sold). Although the LIFO inventory balance is the difference between ending inventory gross and net of the current period LIFO reserve, the LIFO expense is the difference between the current & prior period LIFO reserve and represents the current period increase to cost of goods sold. Using the data from the illustrations above, the example below shows the 2022 year end balances after the LIFO general ledger adjusting journal entry has been made:

Illustration 7. Post LIFO Calculation Inventory Balances – Year 2 on LIFO

Using the data from the illustrations above, Illustration 9 below shows both the current period & cumulative after-tax cash savings from LIFO.

Illustration 8. After-tax Cash Savings Created from Years 1 & 2 on LIFO

As shown above, the year two after-tax cash savings from LIFO was between $1M – $1.5M under FIFO & average cost when assuming a 30% tax rate. This amount can also be more simply calculated by taking the product of the current period LIFO expense & a company’s tax rate. The LIFO expense represents the current period increase in the current vs. prior period’s LIFO reserve (called LIFO income when current vs. prior period LIFO reserve decreases). The cumulative after-tax cash savings from LIFO represents the sum of the Year 1 & Year 2 after-tax cash savings from LIFO. It can be more simply calculated by taking the product of the current period LIFO reserve & a company’s tax rate.

• LIFO Index Computation Method:
  • Dollar value method– A shortcut cost flow method which measures inventory layers in terms of dollars rather than physical units. Inventory items are grouped by pools and are priced in terms of each pool’s aggregate base year cost. The result is compared to each pool’s aggregate base year cost at of the end of the prior year to determine whether the inventory levels have increased or decreased.
  • Specific Goods Method (Unit LIFO)– An approach to applying LIFO in which changes in the quantity of individual types of inventories are the basis for determining whether the inventory levels have increased or whether a portion of the existing inventory has been liquidated.
• LIFO Election Scope:can be selective (by stage of production, product groups, departments, business segment, parent on LIFO but subsidiary is not, etc.) with these exceptions:
  • Manufacturers using Natural Business Unit Pools (NBU)
  • If IRS Technical Advice Memorandum would prevent selective elections within IPIC pooling method
• Item Definition Method:
  • Individual items
  • Fungible commodities measured in gallons, pounds, board feet, etc.
• Inflation Comparison Period:
  • Link-Chain Method-Compare current year-end prices to prior year-end prices
  • Double-Extension Method-Compare current year-end prices to base-year prices
• Current Year Cost & Layer Valuation Method:
  • Latest acquisitions (FIFO)
  • Earliest acquisitions
  • 12-month moving average or rolling-average (i.e. weighted-average or average cost)
• LIFO Pooling Method:
  • Resellers (retailers & wholesalers)-By line, type or class of goods
  • Manufacturers:
    • Natural Business Unit pools (separate pool required for parts purchased for resale)
    • Raw materials content pools
    • Multiple pools
  • IPIC pooling method using Consumer/Producer Price Index major groups (for IPIC method taxpayers)
• Inflation Measurement Source:
  • Internal indexes:
    • All inventory items used
    • Representative sampling (index method)
  • External indexes – IPIC method:
    • BLS Index Selection:
      • Consumer Price Indexes (CPI)
      • Producer Price Indexes (PPI)
    • Index timeframe selection:
      • Final Indexes
      • Preliminary Indexes
    • Discontinued categories treatment:
      • Compound inflation method
      • Substitute index method
    • Weighted-Average pool index calculation method:
      • 10% method
      • Most detailed category method