LIFO Election

The LIFO method (last-in, first-out) is the most beneficial inventory-based tax savings strategy because it uses inflation to create material long-term benefits (LIFO creates a tax benefit when there’s inflation), and tens of thousands of companies use LIFO because of this (most companies use LIFO in perpetuity  after an election is made since the tax benefits become bigger for every subsequent inflationary period). Since the LIFO tax benefit amount is primarily tied to the amount of inflation measured in a given period (for example, a 5x bigger LIFO tax benefit will occur in a period with 10% inflation compared to a period with 2% inflation), thousands of companies have elected LIFO because of the unprecedented inflation that’s occurred over the last few years. When there’s inflation, LIFO creates a tax benefit by lowering the inventory value and increasing cost of goods sold, which in turn reduces taxable income.

• Tax benefits
  • During periods of rising costs, LIFO:
    • Lowers federal & state income tax payment & provides more after-tax free cash flow than all non-LIFO methods
    • Ensures taxes aren’t paid on goods that have yet to be sold & improves ability to replenish/maintain an adequate level of inventory
    • Allows companies to grow business, reduce debt & interest expense
  • Can be expected to create material long-term tax benefits because inflation occurs more frequently than deflation in most industries & LIFO creates an additional tax benefit for each inflationary period
• Similar to real GDP adjustment
  • Widely accepted economic metrics such as real GDP are adjusted for inflation to prevent growth rate being diluted by price increases
  • LIFO works in a very similar manner to the real GDP adjustment by charging/transferring the inflationary component of the ending inventory value to cost of goods sold and removing artificial profits from income
• GAAP accounting method
  • LIFO is an accounting method permissible under GAAP, not just a tax incentive
  • During periods of rising costs, income is most clearly reflected by using LIFO because it matches current costs with current revenues
  • LIFO is the most conservative measure of income compared to non-LIFO methods during periods of rising costs
• Election year LIFO tax benefit formula
  • Current year taxable income reduction from LIFO (aka LIFO expense) = Prior year end inventory balance * Current year inflation rate
  • Current year LIFO tax benefit = Current year LIFO expense * Combined federal + state tax rate
  • Election year LIFO tax benefit example
    • Inputs
      • Prior year end inventory balance at cost: $10M
      • Current year inflation rate: 5%
      • Combined federal & state tax rate: Federal (21%) + State (9%) = 30%
    • Outputs
      • Current year LIFO expense: $10M * 5% = $500K
      • Current year LIFO tax benefit: $500K * 30% = $150K

LIFO can be easily implemented and maintained with minimal administrative burden and costs when the calculation is outsourced to LIFOPro. Learn more about at our Turnkey outsourcing solutions page!

How LIFO Works & LIFOPro's Offerings

Effect of Inflation on Financial Statements & Tax Return

Does the Chosen Inventory Valuation Method Need to Match the Physical Flow of Goods?

The actual flow or physical movement of goods does not need to match the inventory costing method used to value inventory (aka cost flow assumption). The most two most predominant inventory valuation methods can be simplified as follows:

• LIFO:
  • Matches current costs with current revenues, thereby reducing income & providing a better measure of current earnings
  • Commonly called the income statement approach as it provides the clearest reflection of income & costs of goods sold (removes inflation component from income)
• FIFO (first-in, first out):
  • Ending inventory most closely matches the current costs since it consists of most recent purchases
  • Commonly called the balance sheet approach because it most closely matches physical flow of goods
  • Charges oldest costs against more current revenue, and creates artificial inventory profits

Are Unit Costs Required to be Tracked on a LIFO Basis in Accounting Systems Incident & Subsequent to Adoption?

Because of the advantages of the dollar-value method & disadvantages of the unit LIFO method, almost all companies using LIFO track and value inventories in their accounting system on a FIFO, average cost or standard cost basis for the following reasons:

• They use the dollar-value method which requires for unit costs to be tracked and valued on a non-LIFO basis
• Most accounting systems are designed to track and value inventories using FIFO, average cost or standard cost
• Companies often base their pricing decisions on a FIFO, average cost or standard cost assumption
• Recordkeeping on a non-LIFO basis is easier since LIFO does usually not approximate the physical flow of goods
• Profit-sharing & other bonus arrangements often depend on a non-LIFO cost flow assumption

One of the biggest misconceptions is item/unit costs must be tracked and valued on a last-in, first out basis once LIFO is adopted. Although this is not true, it’s a misnomer that causes many companies to not to use LIFO. The reality is there are two methods or options how goods are to be tracked and valued on a LIFO basis, which are as follows:

• Dollar-value method: The dollar-value method measures inflation in terms of the total dollar value of the inventories at a FIFO, average cost or standard cost basis, not by the physical quantity & unit cost on a LIFO basis. Under this method, inventories continue being tracked and valued on a non-LIFO basis in perpetuity even incident & subsequent to adopting LIFO. When the dollar-value method is used, a top-side adjustment is recorded to account for the difference between the inventory value at cost (FIFO, average cost etc.) & the LIFO inventory value. When using the dollar-value LIFO method, item/unit costs are never “LIFO-ized”. What instead occurs is that goods continue to be tracked and valued under a company’s existing method, and at the end of the year, an inventory report showing the quantities and item/unit costs on a non-LIFO basis is generated and exported out of the accounting system in order to calculate inflation & perform the total LIFO inventory value. Once this occurs, inflation is calculated outside of the accounting system, layer at base year cost and LIFO cost are determined, the total LIFO inventory value is determined, the change between the current & prior period’s LIFO reserve is computed, and a top-side journal entry is recorded to adjust cost of goods sold and LIFO reserve (many companies outsource this work to LIFOPro or license our software to automate their in-house dollar-value LIFO calculation). Simply put, the dollar-value method avoids LIFO’s most undesirable characteristics by allowing companies to maintain their existing accounting systems on a non-LIFO basis, and only requiring for a top-side journal entry to be made annually. Because of this, the vast majority of companies on LIFO use the dollar-value method.
• Specific goods method (aka unit LIFO): The unit LIFO method is most often illustrated in tutorials and taught in college accounting courses because the underlying concept is simpler to illustrate than the dollar-value LIFO method. In reality, integrating the unit LIFO method in a perpetual accounting information system is extremely burdensome & sometimes to costly to implement. Under this method, item costs are tracked on a LIFO basis, and the accounting system must be set up in a manner to assume a last-in, first out basis cost flow assumption, meaning the sales of goods must be set up in a manner where the newest goods are sold first and the oldest items remain in stock. Said another way, each item’s unit cost must be LIFO-ized & the total inventory value on a LIFO basis is determined by taking the sum of the extended LIFO cost of all items. Under this method, companies often maintain two separate cost flow assumptions within their accounting information system: 1. Costing method used in the existing accounting system 2. unit LIFO method. One additional shortfall of the unit LIFO method is that it creates a materially lower tax benefit over a long period of time when compared to the dollar-value LIFO method. This is due to the fact that when new items enter into inventory and other items are no longer stocked (due to being discontinued or new items replacing them), the LIFO reserve associated with the items no longer stocked is recaptured under the unit LIFO method, but is retained under the dollar-value LIFO method as long as the total dollar value of the new or replacement goods is greater than or equal to the total value of the goods no longer carried. Because of this, very few companies use the unit LIFO method.

IRS Regs. §1.472-2(e) requires income to be reported and inventories to be valued on a LIFO basis on the face of the income statement and balance sheet beginning in the same year that LIFO is adopted for tax purposes. This is commonly referred to as the LIFO conformity rule. An overview of the LIFO financial reporting disclosure rules and alternatives are listed below.

• LIFO Disclosures
  • Face of the annual or year end income statement must present income, profit or loss using the LIFO method beginning no later than the year that LIFO is adopted for tax purposes
  • Once LIFO has been elected for tax purposes, income, profit or loss must be computed using LIFO on the face of all subsequent annual financial statements (unless LIFO is terminated for tax purposes)
• Non-LIFO Disclosures: The following non-LIFO disclosures and information are allowed within financial statements while also maintaining LIFO conformity compliance (see IRS Regs. §1.472-2(e)):
  • Supplemental and explanatory information using a non-LIFO method – Includes anything other than the primary presentation of the income statement, which includes the following:
    • Notes to the income statement
    • Appendices & supplements to the income statement
  • Other reports included in the financial reports, such as:
    • Management’s discussion and analysis
    • Statement of changes in financial position
    • Letters to shareholders, partners or other stakeholders
    • Summary of key figures
  • Inventory asset value disclosures
• Internal Management & Interim Reports
  • Internal Management Reports – The use of a non-LIFO method is allowed on all portions of internal management reports as long as the reports will not be issued or released to parties outside of the organization. Examples include earnings projections, budgets, and sales forecasts.
  • Interim reports – If issued in accordance with GAAP, same LIFO disclosure rules described above apply. If not issued in accordance with GAAP, then interim reports are not required to be presented on a LIFO basis (exception – series of interim reports that can be used to ascertain income, profit & loss by combining those reports)

Interim LIFO Estimate Best Practices

• Companies that don’t issue interim financial reports are not required to perform interim LIFO estimates
• Companies that issue non-GAAP interim reports are also not required to perform interim LIFO estimates
• Companies perform interim LIFO estimates for a wide array of reasons, including:
  • Financial reporting compliance – Under Generally Accepted Accounting Principles, an estimate for the interim cost of sales is required for interim reporting purposes. Because of this, companies issuing GAAP financial statements include an estimated LIFO adjustment in their interim reports.
  • Tax – Although tax law defines LIFO as an annual calculation, many companies perform interim estimates in order to incorporate the LIFO effect into their quarterly estimated tax payments
  • Forecasting and planning – Many companies perform at least one interim LIFO estimate in order to properly forecast and plan the estimated LIFO effect on their bottom line. An added benefit of doing so is to smooth out the effect of the estimated LIFO reserve change over the course of the year as opposed to booking a single LIFO adjustment at year end. An added benefit of forecasting & planning is that one can avoid material or unexpected surprises from LIFO at year end.
  • Maximize the LIFO reserve increase (or minimize the decrease) –When there’s inflation, a minimum “Current-year cost” balance is required to avoid what is known as layer erosion effect LIFO income (Current-year cost can be thought of as inventory at cost i.e., FIFO or average cost). If the Current-year cost balance is below the minimum required amount, layer erosion effect LIFO income can erode or completely wipe out the LIFO expense created by inflation for that period (or in some cases, a net LIFO reserve decrease can occur from substantial layer erosion income). Because of this, some companies will plan their year end purchases to achieve the most desirable LIFO results to minimize the effects of layer-erosion LIFO income.

• • Misconception #1: The administrative burden and/or costs outweigh the benefits of LIFO

    • Clarifications

      • Item quantities and costs remain being tracked in accounting system the same way they did prior to electing LIFO; only accounting system change is to add a contra inventory account called the LIFO reserve
      • LIFO’s administrative burden is VERY LOW when outsourcing the calculation to LIFOPro & the tax benefits are FAR GREATER than the outsourcing costs!
      • Our outsourcing clients’ only recurring LIFO-related requirements is to annually prepare/send a preexisting inventory report to LIFOPro & record an adjusting journal entry using the amounts included in your LIFOPro report package!

  • Misconception #2: LIFO tax benefits will be minimal because of high inventory turns or low inflation

    • Clarification: Under the dollar-value LIFO method, current and prior year end unit costs are compared to calculate inflation and determine the LIFO tax benefit. Accordingly, inventory turnover plays no part in the inflation calculation since 12 months inflation is calculated on all items regardless of sales volume.

  • Misconception #3: LIFO will compromise bank covenants or complicate employee compensation

    • Clarifications
      • Financial statements can include disclosures or supplemental schedules showing income & profitability on a FIFO basis for comparability purposes as long as the face of the income statement presents income on a LIFO basis
      • Internal management reports can be presented on a FIFO basis

  • Misconception #4: Actual internal costs must be used to measure LIFO inflation

    • Clarification: Most of LIFOPro’s clients use Bureau of Labor Statistics Consumer/Producer Price Indexes to measure inflation, thereby minimizing reliance on internal inventory accounting records & simplifying interim estimates

  • Misconception #5: LIFO only creates a tax benefit when the CY ending inventory balance is higher than PY

    • Clarification: LIFO can create a tax benefit when the current year end FIFO balance is lower than the prior year end balance as long as there’s inflation & the tax benefit created from inflation is greater than the recapture resulting from layer erosions (aka liquidations)

Accounting for LIFO: Using Dollar-value Method

• When dollar-value LIFO method is used, accounting functions such as purchases and sales are tracked and recorded in the accounting system the same way they were prior to the LIFO election.
• Item costs are NEVER tracked on a LIFO basis under this method. Instead, LIFO is accounted for as a top-side journal entry at year end.

Figure 1. Inventory Physical Cost Flow Activity: 2025 Year End

Figure 2. Year End Inventory Balances: Gross of LIFO

Figure 3. Year End Inflation Calculation – Item Detail

Figure 4. Year End LIFO Calculation Summary

Figure 5. Year End LIFO Adjusting Journal Entry

Figure 6. Year End Inventory Account Balances: Net of LIFO

Want to find out how much your LIFO tax benefit could be? LIFOPro makes scoping out a LIFO election easy! Why reinvent the wheel to scope out a LIFO election when you can obtain complimentary comprehensive analysis from the leading LIFO experts? Make the decision to elect LIFO with the utmost confidence, fully understand the risks/rewards of LIFO, and simplify the LIFO onboarding/implementation process with our complimentary LIFO Election Benefit Analysis.

Getting your free benefit analysis is quick and easy and only requires a minimal amount of information that’s readily-available in your accounting system. With our dedicated team & powerful software, LIFOPro minimizes the effort required by companies & CPA firms to evaluate a LIFO adoption.

Companies obtaining a free election benefit analysis will receive a PDF report & turnkey outsourcing solutions fee quote within one week of receipt of your request. LIFOPro offers free discovery calls before or after obtaining your benefit analysis. Use the links below to request your benefit analysis today or learn more!

LIFOPro has developed a proprietary scoring system to identify good LIFO candidates & provide LIFO election recommendations, which requires for the following criteria to be met:

• Historical Inflation Frequency: Inflation in 11 or more of the last 20 years (determined by assigning BLS CPI/PPI categories to current period’s product mix & performing 20Y pro forma IPIC LIFO calculation). Best LIFO candidates have high inflation frequency & low likelihood of deflation/LIFO recapture
• Historical Average Annual Inflation Rate: Must be ≥ 1%. Best LIFO candidates have historical average annual inflation rates of well above 1%.
• At least $2M – $5M of inventory: Is more subjective because this amount is dependent on the following:
  • Historical average annual inflation rate: Higher the rate, lower the minimum inventory balance & vice versa
  • LIFO election year inflation rate: Same as historical average annual inflation rate
  • Company’s tax rate & perceived benefit of tax deferral/savings from LIFO

In the event that the following criteria listed above is met, a current year LIFO election recommendation is made if the current year inflation rate in the potential election year is greater than or equal to the historical average annual inflation rate calculated by LIFOPro

To recap, the following criteria should be met to make a LIFO election for your company’s upcoming year end:

1. Historical average annual inflation rate is greater than or equal to 1%
2. Consistent inflation (11 or more of the past 20 years)
3. At least $1-5 million in inventory & profits will be reported on tax return before applying LIFO reserve
4. Election year inflation is estimated to or will be greater than or equal to the historical average annual inflation rate

For companies with inflationary inventories, LIFO acts like an annuity that provides annual returns, and the long-term benefits can be substantial. Choosing the right time to start using LIFO will allow you to maximize the tax benefits that it provides.

Election Timing

• LIFO creates a tax benefit when there’s inflation, but creates a tax liability when there’s deflation
• LIFO tax benefit amount is dependent on the amount of inflation measured in the year of election (prior or future period inflation can’t be used!)
• Because of the two above facts, LIFOPro requires 1 or both of the following election timing KPIs to recommend a current year election:
  • Current year LIFO tax benefit multiplier is ≥ 1 (CY inflation rate & tax benefit will be as much or more than the historical norms)
  • Current year inflation rate is ≥ 2%
• Meeting one of the two above election timing recommendation KPIs ensures the following:
  • Maximizes election year LIFO tax benefit
  • Ensures election year LIFO tax benefits are greater than first-year implementation costs
  • Maximizes the likelihood that material LIFO tax benefit will remain in the event of future potential LIFO recapture

LIFO Election Scoping & Timing

• LIFO is applied prospectively beginning in the year of election
• The election year LIFO tax benefit is calculated based on the annual inflation rate measured as of the year end date. For example, a December year end company electing LIFO for the 12/31/2025 year end will measure the annual inflation rate by comparing CY or 12/31/25 & PY or 12/31/24 costs.
• Tariffs will create a one-time increase to inflation in the first period they’re incurred if the same tariff rate is in effect for two consecutive periods
• Companies seeking to capture the tariff component of the tax benefit must elect LIFO in the first period the initial or increased tariff costs are incurred
• Events such as tariffs or high inflation periods represent the best time to elect LIFO because the first year tax benefits will be exponentially higher than they would be when electing during a normal inflation period

5 Year LIFO Tax Benefit Comparison: Differential Between Electing LIFO in a High vs. Normal Inflation Period

Figure 1. LIFO Calculation Summary: High Inflation Period – 20% Election Year Inflation (2025)

Figure 2. LIFO Calculation Summary: Normal Inflation Period – 2% Election Year Inflation (2026)

Figure 1.1 Top LIFO Candidates by Bureau of Labor Statistics Producer Price Index (BLS PPI) Major Commodity Group

Figure 1.2 Top LIFO Candidates by BLS PPI Subgroup

Is your company considering electing LIFO? Get a free benefit analysis from LIFOPro! We’ll build a comprehensive case study delivered to you in the form of a report containing everything you need to make an informed decision while considering a LIFO election. This complimentary, comprehensive analysis is only available from the experts at LIFOPro. Submit your LIFO benefit analysis questionnaire today by clicking the button below!

LIFO Benefit Analysis Questionnaire
How to Easily Implement LIFO
How LIFO Works

LIFOPro offers turnkey outsourcing solutions to allow companies to outsource all LIFO-related work to us! Listed below are the key steps to streamlining the analysis, calculation & implementation steps required to elect LIFO in the year of adoption. With our outsourcing model, companies can obtain material tax benefits from electing LIFO in the following four simple steps:

• Step 1: Analysis
• Step 2: Onboarding
• Step 3: Calculation
• Step 4: Reporting & change implementation

LIFOPro’s Turnkey Outsourcing Solutions Process Flow: Election Year

LIFOPro’s Turnkey Outsourcing Solutions Process Flow: Recurring (Optional)

Onboarding

Our turnkey outsourcing solutions allows companies to maintain the tax savings from LIFO while avoiding all the hassle. 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

Get a complimentary, no obligation LIFO Election Benefit Analysis & turnkey outsourcing solutions fee quote emailed to you within one week of submitting the request form below!