The last in, first-out (LIFO) method of accounting for inventory is widely used by many manufacturing companies. The question is often posed, “Should we continue to use LIFO, or should we discontinue using LIFO?” Simply stated, it is time to quit using LIFO when there is no longer a benefit that outweighs the cost.
To determine whether there is a benefit, a business must first understand LIFO, which is an inventory valuation method that can result in tax savings for businesses in the United States that use Generally Accepted Accounting Principles (often referred to as “GAAP”). LIFO is not permitted under International Financial Reporting Standards. LIFO is used to closely match current costs against current revenues because of the assumption that recent purchases cost more than previously purchased items and will be sold first resulting in a higher cost of sales. The difference between the current inventory purchase price and previously purchased items are reported in a balance sheet reserve account.
If the inventory prices are subject to significant price fluctuations, the benefit of LIFO may diminish causing a decrease in the cost of sales and an increase in taxable income and, therefore, taxes. A few items that tend to have volatile prices are aluminum, lumber, steel, plastics, and oil. Businesses with inventory items that have significant price fluctuations that are not temporary will need to evaluate the continued benefit of using LIFO. For example, if newer inventory purchases cost less than older inventory or the commodity index for the item is declining, over time, this may result in a decrease in the inventory reserve and an increase in taxable income and taxes. This would indicate there is no longer a benefit if it is not a temporary price change. When there is no longer a tax benefit to using LIFO, the business will need to consider a change to another acceptable accounting method such as first-in, first-out (FIFO) or average cost. For financial statement purposes, the change would be retrospectively applied to prior financial statements.
While LIFO has benefits, an annual evaluation of price fluctuations is needed to determine the continued use of LIFO versus another acceptable method of accounting for inventory. In the existing economy, some of the aforementioned inventory items have seen significant price increases, however, it bears watching, since they do tend to fluctuate significantly. For assistance or questions regarding inventory valuation methods, please contact your HBK Advisor.