Oversupply has caused crude oil price per barrel to slowly fall to its lowest level since the early 2000s. In addition, certain factors in the metals market have driven steel, copper, aluminum and other commodity prices to record lows. If a company’s commodities used as part of manufacturing inputs are at a historical low or future inflationary pressures are expected, there are opportunities to capitalize on these trends. Companies may consider accounting for inventories using the last-in, first-out (LIFO) method rather than the more conventional first-in, first-out (FIFO) method. During an inflationary period for manufacturers’ raw material costs or distributors’ product costs, LIFO results in a higher cost of sales and lower overall taxable income. However, Internal Revenue Code § 472(c) conformity rule requires taxpayers who apply LIFO for tax purposes to also apply it for financial reporting under U.S. generally accepted accounting principles (GAAP). This presents certain challenges for companies looking to capitalize on the LIFO tax incentive.
The table below can help you evaluate the upsides and downsides of the FIFO and LIFO methods.
Accounting for LIFO Inventory
The conformity rule requires companies to apply LIFO in financial reporting; the rule is considered violated if 12 monthly or four quarterly statements that aggregate to a full year’s performance have been issued to shareholders or creditors using a non-LIFO method. Management groups may hesitate to adopt LIFO accounting because they assume it will be a burdensome process and might impact the company’s general operations. However, LIFO inventory accounting can be simplified by using an inflation index under the Bureau of Labor Statistics to determine the LIFO adjustments for year-end financial reporting. The LIFO adjustment essentially becomes a top-sided entry for consideration in year-end financial reporting to adhere to the conformity rule. Therefore, the company sees no day-to-day operational impact to its departments—e.g., the sales department and its costing and quoting of products—or how inventory is costed within its perpetual inventory system.
Income Taxation in Event of Inventory Method Changes
Companies primarily adopt LIFO as an income tax liability-lowering strategy, which essentially is a deferral of income. Other deterrents for companies considering the LIFO method include:
- The impact of voluntarily electing off of LIFO if deflation makes the strategy no longer effective
- Involuntarily electing off of LIFO if it’s suddenly disallowed by the U.S. tax code
- A convergence between IFRS and GAAP
If the inventory method change is voluntary, companies are generally permitted to take the LIFO recapture income into account for tax purposes over four years beginning with the year of the change.
Timing of LIFO Election
A company may defer a LIFO election until after the end of its taxable year, which will allow it to fully vet the decision against published indexes, on-hand year-end inventory levels and market fluctuations through the subsequent evaluation date. Form 970 is the application to use LIFO inventory method; it states the application should be filed with the tax return for the first year the company intends to use the LIFO method and can be filed with an amended return within 12 months of the original filing.
These factors only scratch the surface of the points to consider when evaluating a LIFO election; however, given the current market conditions, it may make sense to perform an analysis.
If you have any questions regarding implementing or evaluating a LIFO method, contact your BKD advisor.