Inflation and the potential for increasing tariffs will likely put many businesses under cash flow pressure. Many may not realize that these circumstances can also create additional tax pressure. This is because inflation and tariffs both raise the cost of purchases. Due to these factors, businesses maintaining inventories inevitably will experience increases in the cost of ending inventories. Whereas the tariffs and inflationary costs must be paid upfront, the tax deduction related to ending inventory costs is “frozen” in that ending inventory balance, waiting for proper recovery during a later year.
The last in, first out (LIFO) inventory methodology can relieve some of this pressure. With LIFO, the business assumes it sold the most recent purchases first (even if the actual flow of goods is the opposite). This scenario has a happy ending for tax deduction purposes in times of inflation and increased costs. Moreover, the deduction for the more expensive items is less likely to be “stuck” in the ending inventory and is more likely to be deducted currently through the costs of goods sold (COGS).
Advantages of LIFO
Implementing the LIFO method of accounting for inventory in an inflationary and tariff-afflicted environment can effectively ease cash flow pressures, thereby enhancing business continuity and competitiveness. An added benefit is that the LIFO method can more clearly represent your company’s actual inventory costs and financial position. Companies in any industry facing rising costs can benefit from the LIFO inventory valuation method. Examples include manufacturing, automobile, oil and gas, food services, convenience stores, and large retailers.
Various LIFO methods and indexes should be analyzed to ensure maximum tax benefits and financial reporting accuracy. Additionally, a business should consult its professional advisor to determine whether all inventory or a specific inventory subset can/should utilize the LIFO method.
When LIFO Doesn’t Make Sense
LIFO books and records can be complicated to maintain. Because it is often represented by an accounting fiction, it is a bit counterintuitive. LIFO also requires conformity between internal books and tax accounting. Moreover, if you utilize the LIFO method for tax reporting purposes, then you must utilize the LIFO method for book and financial reporting purposes. Such conformity means that the LIFO method will reduce reported earnings. For this reason, publicly traded companies rarely use LIFO due to its drag on earnings per share (EPS). However, users of financial statements typically understand the LIFO disclosure and its implications (LIFO is also explained in financial statement footnotes). Lenders and other financial statement users are often able to translate the effect.
The complexity associated with LIFO bookkeeping can be intimidating. Many LIFO calculation variants exist, including some small business versions for companies with sales under $25 million. Fortunately, the IRS accepts simplified LIFO valuation methods like IPIC (Inventory Price Index Computation), making LIFO adoption more straightforward and the ongoing computations easier.
Timing the LIFO Election
The timing of the LIFO election is essential because the LIFO method is required to be applied prospectively for tax purposes. However, timing can be challenging. Because of the need for book and financial reporting conformity, your business has to get tax, accounting, and reporting on the same page at the same time. For instance, when financial statements have already been issued for a given year, it will be too late to consider the LIFO method for that particular year. For calendar year filers, late summer to early fall is often a good time to model the benefits of the LIFO method and discuss adoption.
The procedures associated with LIFO adoption are fairly automatic, where Form 970 must be filed when the tax return is due. Modifications within the LIFO method may require a business to request a change in accounting method on Form 3115. Note other factors to consider when adopting the LIFO method, such as its effect on loan covenants (e.g., working capital). As part of a sale transaction of the business, cumulative LIFO adjustments generally are reversed for tax purposes. Such recapture adjustments trigger additional income tax at ordinary rates.
Takeaway
The LIFO method often produces a quasi-permanent benefit, meaning there is no reversal so long as a company remains in business with relatively constant (or increasing) inventory levels. Some companies have used LIFO for over 30 years, and the benefit over time can be astounding. For example, consider the cost of automobiles 30 years ago—not much by today’s standards. Because the LIFO method treats the oldest automobiles as comprising the balance of ending inventory, cost recovery for the newer models is received immediately through cost of goods sold.
Complexity aside, the LIFO method is well-known, tried, and true. Businesses can navigate economic uncertainties that come with tariff changes and inflationary pressures and emerge stronger by seizing cash flow management opportunities afforded by the LIFO method. Determining whether the LIFO method makes sense for your business requires a careful evaluation of your company’s inventory cycle and evaluation of the LIFO method’s suitability for financial reporting purposes. With the help of your professional team, you can understand the pros and cons associated with LIFO and determine whether you can leverage its benefits to combat inflation and drive growth for your company.
At CBIZ, we understand the complexities of LIFO implementation and the potential benefits it can provide during these volatile economic times. Our team of tax experts possesses the knowledge and expertise necessary to guide businesses through the process and ensure all relevant regulations are followed. Whether you’re looking to maximize tax savings, better reflect inventory costs, or manage potential risks, CBIZ provides the support and guidance you need to succeed. Contact us today.
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