U.S. Generally Accepted Accounting Principles (GAAP) and the Internal Revenue Code allow businesses to choose one of four methods of accounting for inventory, including Last in First out (LIFO). LIFO has been in use since the 1930s but is often dismissed or overlooked. In periods of inventory growth, or periods of economic inflation, as seen recently, LIFO can provide immediate tax benefits.
LIFO matches current costs against current revenue to provide a better measure of current profit margins. During times of inflation, LIFO values the most recently purchased items in “cost of goods sold” as current deductions, while older lower-cost items remain capitalized in inventory. This means that LIFO transfers current costs from the balance sheet to the income statement, thereby reducing taxable income and creating long-term tax savings.
When prices are rising or inventory is growing—many companies have experienced both over the past couple of years—the increase in LIFO reserves will create immediate tax savings by reducing taxable income. Businesses that have large inventories, such as manufacturers, distributors, retailers, and automobile or equipment dealerships, can benefit from LIFO.
LIFO election options
Companies considering LIFO elections have options. The Inventory Price Index Computation (IPIC) method uses the Consumer or Producer Price Index (CPI or PPI) to measure the inflation used to calculate the annual change in LIFO inventory. Many companies take advantage of this opportunity because it allows them to maximize their LIFO benefits and is far less arduous than calculating via an internal index and manually tracking LIFO layers or specific items of inventory. Calculating an internal index is typically a major undertaking; companies can avoid the hassle if they switch their inventory accounting methods for both book and tax purposes.
Companies already on LIFO may also choose to adopt IPIC for tax purposes while continuing to use internal indexes for internal LIFO calculations. This will result in annual tax differences that should be considered in tax planning. You could generate a higher LIFO expense for tax purposes without increasing the amount of the internal LIFO expense if the internal indexes used for financial reporting are less than the IPIC tax indexes. In many cases, because IPIC is a national measurement, it will create more favorable tax results than internally calculated indices.
The Bureau of Labor Statistics recently released the December 2022 Consumer Price Indexes. While we are beginning to see some declines, most item categories recorded price increases throughout 2022, including the “all items” index, which rose 6.5 percent.
The following manufacturing sectors are typically most likely to elect LIFO:
The list is hardly all-inclusive. Other types of manufacturers and many businesses in other industries can also reap significant benefits by electing LIFO.
If you would like to discuss how LIFO can benefit your company, please contact a member of HBK Manufacturing Solutions at 330-758-8613 or firstname.lastname@example.org.
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