LIFO: back in style for US companies

How and when it works

In situations with both rising costs and increasing inventory levels, LIFO results in the higher, more recent costs flowing through cost of sales with the lower, older costs in inventories. Its effects are muted or even reversed when inventory levels or costs decrease.

LIFO may be elected for all inventories or any component of inventories, such as raw materials, labour, outside processing or overheads. It may be elected for specific products or business lines. Of the many choices of methods available, the earliest acquisition method allows up to an additional year of inflationary effects to be captured in the calculations. LIFO calculations are typically done outside of a company’s ERP system, avoiding costly or confusing software changes.

Limitations

The LIFO Conformity Rule requires that companies using LIFO for tax reporting must also use LIFO for financial reporting purposes.

LIFO is elected by way of a form filed with a company’s federal tax return. Thus, a company may evaluate the advantages of LIFO up to the filing date of the tax for the first year of using LIFO. The election is subject to IRS approval.

LIFO may also be revoked, also subject to IRS approval. When revoked, the LIFO reserve will be added to taxable income evenly over four years, beginning with the year of change. Further, LIFO may not be re-elected for at least five years.

Summary

Growing US companies with upward pressure on material, labour and overhead costs may benefit from electing LIFO. A LIFO election, however, is a significant decision and should be carefully evaluated. Equally important is the careful analysis of the many options within the LIFO election, which are not changeable once elected.

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