LIFO Q & A: First-time LIFO Elections

Why Should Companies Elect LIFO in 2021?

• LIFO remains to be the most valuable inventory-related tax savings tool
• In 2021, unprecedented inflation has created once in a lifetime LIFO tax savings opportunities in a wide range of industries
• There has been extreme inflation measured across the board so far this year. In metals and metal products, there’s been 40% year to date inflation. In Chemicals and allied products, there’s been 21% year to date inflation. In Rubber and plastic products, there’s been 18% year to date inflation. I’ve just named a few, but nearly every type of good & industry is seeing either record-high or well above-average inflation.
• A quick formula for estimating the potential benefit of LIFO election is to take the product of a company’s prior year end inventory balance & year to date inflation rate & multiply that result by their combined tax rate. For example, a company who had a $10M prior year end inventory balance, a 10% year to date inflation rate & a 40% tax rate would have $1M in taxable income reduction & $400K of after-tax cash savings from LIFO.
• The threat of LIFO repeal is minimal. LIFO repeal was excluded from the most recently passed infrastructure bill & is also expected to be excluded from the Build Back Better spending bill
• Knowing this, the chances of tax rates increasing & inflation persisting is far higher than the chances of LIFO ever going away
• The timing of when to elect LIFO is key since the change is treated prospectively, so it’s important to elect LIFO in a period such as 2021 when there’s record high inflation being measured.

What are the biggest misconceptions about LIFO?

• Misconception #1: Item costs & the physical flow of goods must be tracked on a LIFO basis
  • Under the specific goods or unit LIFO sub methodology, the value of ending inventory is determined by tracking item costs & the physical flow of goods on a LIFO basis.
  • Although taxpayers are allowed to use unit LIFO, the vast majority of businesses that are on LIFO use what’s called dollar-value LIFO because it avoids all the undesirable characteristics of unit LIFO.
  • Under dollar-value LIFO, the method used to determine the value of ending inventory is completely decoupled & independent from the method used to track item costs & the physical flow of goods. In other words, item costs & the physical flow of goods are tracked & valued within your accounting system under the same cost flow method used prior to going on LIFO when dollar-value is used.
  • For example, a company who used FIFO prior to adopting dollar-value LIFO would continue tracking item costs using FIFO after switching to LIFO. The same can be said for companies using average cost, weighted average cost or standard cost & subsequently adopt dollar-value LIFO.
  • This is because under dollar value LIFO, a side calculation is made at the end of the year to adjust the value of ending inventory from cost to LIFO. After this side calculation is made, a journal entry is recorded to adjust the cost of goods sold & LIFO reserve balances. Under dollar value LIFO, the only change that’s made to your accounting system after adopting LIFO is to add a contra-inventory subledger account called the LIFO reserve. This balance sheet account represents the difference between the value of inventory at cost & inventory at LIFO. It’s the vehicle for reducing the ending inventory balance, increasing cost of goods sold, reducing pre-tax income & generating tax savings from LIFO.
  • Under dollar-value LIFO, the LIFO reserve balance is never allocated at the item level, and no changes are required in terms of how item costs are valued or how the physical flow of goods are tracked.
• Misconception #2: Management forecasting & planning functions will be severely complicated by using LIFO
  • A frequent fear of management & cost accountants is that LIFO will impair their abilities to perform essential forecasting & planning functions related to purchasing decisions, sales projections & forecasted profits.
  • Under dollar-value LIFO, this misconception is proven wrong. Management & cost accountants can continue forecasting & planning their purchases, sales & profit margins using the cost flow methods that are most representative of current or projected item costs, such as FIFO, average or standard costs.
  • Under dollar-value LIFO, the effect of LIFO is never felt at the item level, so management can rest assured that key internal business decisions related to inventory will remain unaffected & be made using the same historical costing methods.
• Misconception #3: Gross margins & profit-based incentives will be negatively impacted by implementing LIFO
  • Although LIFO effects the balance sheet & income statement, many companies choose to categorize the change in the LIFO reserve as a selling, general & administrative expense on the income statement, which prevents it from effecting gross profit.
  • As a result, companies with incentives & bonuses tied to sales & profit margins can effectively avoid LIFO elections from affecting profit-based compensation.
  • Furthermore, companies often present financial measures such as gross margins, EBITDA & EPS showing both including & excluding LIFO on their financial statements in order to accommodate financial results to be compared to other companies that don’t use LIFO.
• Misconception #4: Internal costs must be used to measure LIFO inflation
  • Although there are legitimate reasons for not wanting to measure price changes using internal costs for LIFO calculations, this misconception ignores the fact that taxpayers are allowed to measure LIFO inflation using externally published government inflation indexes, which is often referred to as the IPIC method, which stands for Inventory Price Index Computation.
  • Under the IPIC method, Bureau of Labor Statistics Consumer or Producer Price Index inflation categories are assigned to items & represents the sole source for measuring LIFO inflation. The benefits of using government indexes include the following:
    • External indexes may result in higher inflation being measured than internal indexes because all BLS indexes are based on domestic production. For example, under the use of PPI, surveys are taken from U.S. based producers based on net domestic sales receipts, which often creates more inflation than imported goods due to the differences of domestic vs. outsourced labor & overhead costs. The result of the higher inflation measured from using external indexes is that LIFO will create more tax savings than internal indexes.
    • Also, external indexes are often less volatile than internal indexes since the BLS indexes are measured using surveys of multiple producers. Accordingly, external indexes are based on a weighted average of the net revenues submitted by survey respondents. This causes any above & below average price changes to be pooled into a single index, which insulates external indexes against extreme price changes more so than any single internally calculated inflation index.
• Misconception #5: Administrative burden & costs of LIFO will outweigh the potential tax benefits
  • For companies using dollar-value LIFO who manage their calculations in-house using Excel schedules, LIFO can be very complicated for the following reasons:
    • The Inflation calculation can be time-intensive. For manufacturers & companies with many unique goods & product lines, the exercise of calculating inflation manually within Excel can be especially complex & time-intensive.
    • The LIFO layer & reserve calculations can also be complicated & error-prone for the following reasons:
      • For one, in any given year, a totally different set of math steps are required to be used to calculate the LIFO layers & LIFO reserve. This is because the LIFO math steps required are different when there’s an increment versus when there’s a decrement.
      • Furthermore, companies with multiple LIFO pools, business units or entities have to manage multiple LIFO calculations
      • No one-size fits all Excel LIFO template or macro exists to automate the LIFO layer & reserve computations
  • Although LIFO calculations can & often are truly complicated because of the reasons just mentioned, LIFOPro’s mission is to make being on LIFO as simple as possible.
  • By outsourcing your calculation to LIFOPro, companies can maintain the tax savings of LIFO & avoid the hassle by letting LIFOPro do all the work.
  • By licensing the LIFOPro software, companies & CPA firms can minimize the amount of time & effort required to maintain LIFO calculations in-house.
  • The costs of either solution are nominal compared to the tax savings achieved from LIFO & also is a fraction of the cost of other LIFO service providers
  • As a result, companies can accumulative material long term tax savings from LIFO elections with a minimal amount of administrative burden

How can companies determine if they are a good LIFO candidate?

• LIFO Election Benefit Analysis
  • LIFOPro offers complimentary analysis to quantify the potential tax savings that could be achieved from electing LIFO.
  • This analysis includes the current year projected tax savings from LIFO, a pro forma LIFO calculation showing the historical inflation over the past 20 years & a How LIFO Works Appendix detailing valuable concepts for companies considering LIFO elections
  • Included with our complimentary analysis is a turnkey outsourcing solutions fee quote
  • Request your complimentary analysis here (turnkey outsourcing solutions fee quote included with analysis PDF report): LIFO Election Benefit Analysis Request Form
• LIFOPro’s 2021 LIFO Lookout & Top Election Candidates Guide
  • 2021 Guide is available now on the lifopro.com blog page & has been updated to include year to date inflation rates.
  • We’ll continue to update it monthly in December & January following the BLS releasing November & December ‘21 CPI & PPI.
  • View our guide here: 2021 LIFO Lookout & Top Election Candidates Guide

Can companies easily implement LIFO?

• LIFOPro makes being on LIFO as pain-free as possible
• With our turnkey outsourcing solutions, all aspects of a company’s LIFO calculation can be outsourced to LIFOPro, including:
  • Requesting the raw data required to complete the LIFO calculation & organizing the documentation provided by the client
  • Completing the inflation index, LIFO layer & LIFO reserve calculation, which represent the front & back ends of all dollar-value LIFO calculations
  • Maintaining the LIFO permanent files within our LIFOPro software & delivering a LIFOPro PDF report package that includes comprehensive calculation documentation & all amounts required for financial reporting & tax return purposes
  • Performing interim LIFO estimates & ad-hoc projections
  • Integrating §263A UNICAP costs into our LIFOPro reports
  • Completing LIFO-related accounting method changes, including layer history rebasing, pool combinations & splits
  • IRS forms 970 & 3115 preparation for LIFO elections & LIFO-related method changes
  • The LIFOPro software can also be licensed by companies & CPA firms
  • Companies & CPA firms can rest assured knowing that LIFOPro will offer comprehensive, affordable solutions for all their LIFO needs

LIFOPro’s “How To Easily Implement LIFO” Blog

Get a LIFO Election Benefit AnalysisSample LIFO Election Benefit Analysis ReportLIFO Election Benefit Analysis Documentation Request

2021 LIFO Lookout & Top Candidates GuideLIFOPro's 2021 Top LIFO Candidate List