2025 LIFO Opportunities & Strategies Guide

How LIFO Works

During periods of inflation, the LIFO method is most clearly reflective of income because it most closely matches current costs with current revenues. Mechanically speaking, when costs are rising, LIFO charges the inflationary component of ending inventory to cost of goods sold (lowers ending inventory & raises COGS). As a result, LIFO removes artificial profits created from price inflation, which in turn reduces federal and state income tax payments.

Effect of Inflation on Financial Statements & Tax Return

Why Use LIFO?

The LIFO method (last-in, first-out) is the most beneficial inventory-based tax savings strategy because it uses inflation to reduce taxable income, which in turn increases cash flow. Because of this, tens of thousands of companies use the LIFO method. There are many reasons to use the LIFO method, which include the following:

• 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
  • Creates material long-term tax benefits for industries where inflation occurs more frequently than deflation since LIFO creates an additional tax benefit 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 similarly 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

• Is the most conservative GAAP inventory valuation 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 inventory valuation method because inflation occurs far more often than deflation in most industries

LIFO Tax Benefit Formula

• Current year taxable income reduction (also known as LIFO expense): Prior year inventory balance * Current year inflation rate
• Current year tax liability reduction from LIFO (aka tax deferral or after-tax savings from LIFO): Current year LIFO expense * Current year combined federal and state tax rate

Five Year LIFO Calculation & Cost-Benefit Analysis: Machinery & Equipment Wholesaler

View/download LIFOPro’s 2025 Top LIFO Election Candidates & Tax Benefit Calculator Excel file by clicking this link: LIFOPro’s 2025 Top LIFO Election Candidates & Tax Benefit Calculator

LIFO Key Performance Indicators

Key performance indicators or KPIs provide a reasonable means of determining the following:

• The size or amount of the benefit from using a certain approach or method
• The probability or likelihood that using a certain approach or method will provide a benefit
• If a certain approach or methodology is beneficial or preferable to alternatives based on the size & probability of the benefit
• The most appropriate or beneficial timing for adopting a certain approach or method based on comparing current & past benefits

The KPIs listed below allow for objective metrics to be used to weigh LIFO’s risks and rewards and costs vs. benefits and should be considered an integral component of the LIFO election scoping process:

• Historical average annual inflation rate

  • Forecast the long-term and average annual tax benefit that LIFO will create in the future (future LIFO tax benefit amount)
  • Determine if LIFO is a preferable method

• Historical inflation frequency rate (aka LIFO tax benefit frequency rate)

  • Forecast how often LIFO will create a tax benefit each year in the future (future LIFO tax benefit probability)
  • Determine if LIFO is a preferable method

• Current year inflation rate

  • Estimate the LIFO tax benefit that would be created from electing LIFO this year (current year LIFO tax benefit amount)
  • Determine the appropriate or most beneficial timing of the LIFO election

• LIFO tax benefit multiplier

  • Compare the current period’s inflation rate & LIFO tax benefit to the historical average
  • Determine the appropriate or most beneficial timing of the LIFO election

LIFOPro’s complimentary benefit analysis uses the above KPIs to assist in the LIFO election scoping process.

Common LIFO Misconceptions

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 are 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 (BLS CPI/PPI) 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 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)

Key LIFO Election Considerations

LIFO Election Scoping & Timing

LIFO is applied prospectively beginning in the year of election, and 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. A comparison of the taxable income reduction & resulting tax benefits from electing LIFO during a high vs. normal inflation period is illustrated below.

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

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

As seen above, a company with $10M in inventory electing LIFO in a high inflation period (2025) had a total LIFO tax benefit of $569K after its fifth year on LIFO. Assuming that same company waited until the following year to elect LIFO during a normal inflation period (2026), the total LIFO tax benefit after its fifth year on LIFO was $172K, which is about one third of the total LIFO tax benefit obtained when electing during a high inflation period.

LIFO Disclaimers

Although LIFO typically provides material long-term tax benefits, there are certain events that can trigger taxable income when using the LIFO method. Those are as follows:

• Portion of LIFO reserve is recaptured into taxable income in periods when either of the following occurs:
  • Deflation
  • Material inventory liquidations (for example, a 50% decrease in the current vs. prior year’s ending inventory balance)
• 100% of LIFO reserve will be taken back into income when either of the following occurs:
  • C to S Corp conversions
  • Business is sold in a taxable transaction such as a sale of assets (LIFO reserve is usually not recaptured if it’s a non-taxable transaction or in the form of a stock purchase)
  • Termination of LIFO election: Ratably recaptured over a four year period beginning in termination year

Events such as deflation are inevitable in certain industries, but rarely occur in others. Accordingly, understanding the historical inflation frequency is a key consideration to take into account when considering a LIFO adoption. For example, steel mill products have a 60% inflation frequency rate over the last 20 years, which infers that inflation has occurred in 12 of the last 20 years, and deflation has occurred in 8 of the last 20 years. Knowing this, there’s a high likelihood that deflation will occur every few years in industries such as steel mill products, which will cause taxable income to be created in the deflationary periods.

Some view the use of the LIFO method to be a deferral or delay of income tax payments and assume recapture to be an inevitable event. Others perceive LIFO to create a quasi-permanent tax benefit if one were to assume the continued use of the LIFO method in perpetuity. Regardless of one’s view of LIFO, there are selected events that are certain to cause complete recapture of the LIFO reserve into taxable income, such as the ones listed above. Knowing this, it’s important to keep the following in mind:

• There are no limitations on the length of time that LIFO can be used, or on the size of the LIFO reserve. Said another way, LIFO can be used in perpetuity, and there’s no ceiling on the LIFO tax benefit amount.
• LIFO creates a permanent benefit by reducing the interest expense on debt that would have otherwise been incurred if the LIFO method were not used. It also creates a permanent benefit by freeing up the cash required for reinvestment into the business, which in turns increases revenues.

Financial Reporting Disclosure Requirements

• 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 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, sales 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 is a series of interim reports that can be used to ascertain 12 month or full year income, profit & loss by combining those reports)

Inflation Calculation Approaches

The following inflation calculation approaches are available when using the dollar-value LIFO method:

• Internal index
  • Uses actual cost paid to acquire and/or manufacture each good (not the selling price)
  • Includes all applicable cost components (materials, labor, overhead & tariffs)
• External index (aka IPIC method)
  • Uses manufacturer or retail price surveys collected monthly by Bureau of Labor Statistics (BLS; division of Department of Labor)
  • Producer price indexes (PPI) calculated using selling prices charged by U.S. or domestic producers (not their actual cost to acquire and/or manufacture each good)
  • Consumer Price Indexes (CPI) calculated using selling prices charged by U.S. retailers
  • Retailers can use CPI or PPI. Manufacturers/producers/wholesalers must use PPI.

Many companies use the IPIC method for the following reasons:

• Highest long-term LIFO tax benefit in industries where external index inflation has been historically higher than internal index
• Inflation calculation can be simpler than internal index for manufacturers and companies without comprehensive perpetual accounting system
• Less prone to scrutiny by the IRS than internal index since BLS CPI/PPIs are sourced by a government entity

Some companies use internal indexes for the following reasons:

• Companies issuing financial statements in accordance with GAAP may be required to use for financial reporting (see AICPA LIFO Issues Paper)
• Calculation is simpler than IPIC method in certain cases since BLS categories must be assigned to all goods when using IPIC method

The effects of tariffs on inflation & LIFO tax benefits are dependent on inflation measurement source:

• Internal index – Tariffs have a direct effect because inflation is measured using each item’s actual cost, which includes tariffs
• External index – Tariffs have an indirect effect because inflation is measured using selling prices & therefore will depend on the following:
  • Amount of tariff costs incurred by U.S. producers and retailers (many will likely have material tariff costs; others may have less or none)
  • The percentage of tariff costs passed onto customers (some will pass on all tariff costs; others may only pass a portion of it)

The effect of tariffs on the 2025 LIFO tax benefit can be materially different when using an internal vs. external inflation index. With this in mind, it’s imperative to consider all options available prior to adopting LIFO to ensure the methods elected maximize tax benefits. LIFOPro’s complimentary benefit analysis includes comparative internal and external inflation index calculations and submethods recommendations.

LIFO Election Scope: Why the Goods Valued Using LIFO is Not All or Nothing

Some or all goods can be valued using LIFO. A selective election scope infers that less than 100% of inventories are valued using the LIFO method. Although a general rule of thumb is to place all goods on LIFO to maximize the tax benefit, thorough analysis is highly recommended prior to electing LIFO. This is because including deflationary goods in the election scope could materially reduce LIFO’s long-term tax benefits. LIFOPro’s best practices regarding determining the LIFO election scope is described below.

• Perform analysis prior to election to determine if some or all goods have historically been inflationary: Prior to electing LIFO, thorough analysis should be performed where historical pro forma LIFO calculations are made to measure past inflation levels, inflation frequency and the resulting LIFO tax benefits. If there is a diverse product mix or material amounts of goods with differing cost characteristics, further analysis should be performed at a more granular level to determine the historical inflation by group or product type. If all goods have historically been inflationary, the long-term strategy should be to value 100% of the goods using LIFO, but if any material portion of goods have a history of deflation, the short & long-term strategy should be to exclude the deflationary goods from the LIFO election scope.
• Year of LIFO election: When there is a diverse product mix, additional analysis should be performed to determine if all goods have inflation in the year of the LIFO election, or if there are any material portions of goods with deflation. If there is significant deflation in a material portion of goods in the LIFO election year, a best practice is to make a selective LIFO election for the inflationary goods to prevent the deflationary goods from reducing the election year LIFO tax benefit.
• Year proceeding LIFO election: If goods were excluded from the LIFO election scope in the year of adoption but have an inflationary history, a best practice is to expand the election scope to include those goods in the first subsequent period where there is sufficient inflation & LIFO tax benefit to merit doing so (IRS Form 970 must be filed; change is applied prospectively beginning in year of change).
• The following are other examples of why certain goods may be excluded from the LIFO election scope
  • Existing entity using LIFO acquires a business not using LIFO & chooses to keep them off LIFO because the additional tax benefits would be minimal
  • Tax benefits of including certain inventories in the election scope is less than the cost and administrative burden

2025 Top LIFO Election Locks

In 2025, new tariffs were applied and existing tariff rates were increased to a substantial portion of goods imported into the United States. The current average effective tariff rate on U.S. imported goods is 18%, which is nearly 7x higher than the 2024 average effective tariff rate of 2.5%. Since tariffs must be included as a component of inventory costs & can’t be expensed as period costs, they have a direct effect on inflation. In 2025, tariffs have created elevated inflation in most industries when compared to the historical averages. As a result, most companies can obtain material tax benefits from electing LIFO this year.

The most notable LIFO election opportunities from a tax benefits perspective are summarized below by Bureau of Labor Statistics Producer Price Index (BLS PPI) group. The 2025 year to date inflation rates for the eight months ended August 2025 are listed first & the 2025 annualized inflation rates are listed second.

• All commodities: 3.5% & 5.3%
• Processed foods & beverages: 3.6% & 5.3%
  • Meats, poultry & fish: 10.6% & 15.9%
  • Beverages & beverage materials: 3.8% & 5.7%
• Textile products & apparel: 1.5% & 2.2%
• Fuels & related products: 4.7% & 7%
  • Natural gas: 3.3% & 5%
  • Gasoline: 7.1% & 10.7%
  • Asphalt & other petroleum & coal products: 16.3% & 24.5%
• Metals & metal products: 8.9% & 13.4%
  • Steel mill products: 15.3% & 22.9%
  • Nonferrous metals (including copper and aluminum): 14.8% & 22.1%
  • Hardware: 5.6% & 8.4%
  • Plumbing fixtures & fittings: 8.1% & 12.2%
  • Heating equipment: 7.3% & 11%
  • Fabricated structural metal products: 5.4% & 8.2%
• Machinery & equipment: 3.7% & 5.6%
  • Construction machinery & equipment: 4.4% & 6.6%
  • General purpose machinery & equipment: 5% & 7.5%
  • Electrical machinery & equipment: 3.5% & 5.4%
• Furniture & household durables: 3.3% & 4.9%
  • Household furniture: 3.1% & 4.6%
  • Commercial furniture: 4.1% & 6.2%
  • Household appliances: 3.5% & 5.2%
• Nonmetallic mineral products: 2.5% & 3.7%
  • Concrete ingredients & related products 4.7% & 7.1%
  • Asphalt felts & coatings: 3.8% & 5.7%
• Transportation equipment (for manufacturers and wholesalers): 1.1% & 1.7%
  • Motor vehicle parts: 2.1% & 3.1%
  • Aircraft & aircraft equipment (including parts) 1.6% & 2.4%
• Auto dealers
  • New vehicle import dealers:
    • Weighted average inflation rate: 2.3%
    • Low/high inflation range: 0.5% to 5.1%
  • Used vehicle dealers: 3.8% & 7%
  • Parts: 3.1% & 4.6%
• Other dealerships
  • Motor homes: 1.8% & 2.7%
  • Travel trailers & campers: 2.4% & 3.6%
  • Boats: 2.9% & 4.3%
• Miscellaneous products: 3.8% & 5.7%
  • Toys, sporting/athletic goods & small arms: 1.5% & 2.3%
  • Tobacco – 7.8% & 11.7%
  • Medical, surgical & personal aid devices: 1.2% & 1.8%
  • Personal and industrial safety equipment & clothing – 2.7% & 4.1%

Performing High-level Benefit Analysis Using LIFOPro’s 2025 Top LIFO Election Candidates List

LIFOPro offers complimentary election benefit analysis that provides a comprehensive assessment of the risks and rewards of LIFO using your client’s or company’s actual inventory data. Prior to obtaining this analysis, many of our CPA firm partners will perform a high-level benefit analysis because it acts as a pre-screening tool to confirm that LIFO election scoping should occur, and it provides meaningful metrics that can be shared with the client when preliminary discussions occur with them about LIFO. To do so for a single client, take the following steps:

• Step 1: Locate a single BLS group/subgroup/product class within LIFOPro’s 2025 Top LIFO Election Candidates List that most closely matches your company/client’s product mix or industry & proceed to Step 2
• Step 2: Locate the LIFO is Preferable field entry for the selected PPI
  • If the LIFO is Preferable entry is “Yes” – Proceed to Step 3
  • If the LIFO is Preferable entry is “No” – LIFO is not preferable for your client or company & LIFOPro recommends not exploring a LIFO election
• Step 3: Locate the Top 2025 Election Candidate field entry for the selected PPI
  • If the Top 2025 Election Candidate entry is “Yes” — Proceed to Step 5. LIFOPro recommends exploring a 2025 LIFO election and obtaining a complimentary benefit analysis from LIFOPro.
  • If the Top 2025 Election Candidate entry is “No” – Defer scoping out a LIFO election until a future period in time. This is because of one or both of the following reasons:
    • There is deflation for your good, which suggests that electing LIFO would be detrimental from a tax perspective (increase taxable income)
    • The inflation is below the historical average and/or is less than 2%, which would indicate 2025 would be a less than ideal time to elect LIFO from a tax benefit perspective
  • Step 4: Estimate the 2025 tax benefit from electing LIFO
    • 2025 taxable income reduction from LIFO (2025 LIFO expense/reserve): Multiply the year to date or annualized inflation rates shown in the 2025 inflation rate fields by last year’s inventory balance (or calculate a low & high range using both of the 2025 inflation rates shown)
    • 2025 LIFO tax benefit (2025 LIFO after-tax savings): Multiply the 2025 LIFO expense calculated above by your company or client’s combined federal & state marginal tax rate
  • Step 5: Proceed with LIFO election scoping by taking any of the following steps:
    • Contact your client
      • Let them know that part of your firm’s annual year end tax planning initiative, their company has been pre-screened as a good candidate for electing LIFO
      • Based on a high-level analysis, you’d estimate that LIFO could reduce taxable income or create a tax benefit of the amount calculated in step 4 (optional, but often useful in motivating clients to take further action on scoping out a LIFO election)
      • Inform client they can obtain the following to further explore a LIFO election & obtain a better estimate of the potential benefits and the overall requirements of using LIFO:
        • Complimentary LIFO election benefit analysis & outsourcing fee quote
        • Complimentary LIFO discovery call
      • Share the LIFO election benefit analysis questionnaire & document request list with them (or share LIFOPro’s contact information with them)
    • Contact LIFOPro
      • Schedule a complimentary LIFO discovery call for your client and/or firm to attend
      • Obtain benefit analysis questionnaire & document request to share with your client
      • Obtain complimentary LIFO election benefit analysis & outsourcing fee quote
      • Share your client’s contact information with LIFOPro to allow us to work directly with your client in scoping out a LIFO election & obtaining an outsourcing fee quote
    • Schedule a free LIFO discovery call to learn more about LIFO, how to obtain a free election benefit analysis & LIFOPro’s outsourcing solutions:
      • Email or call Bob Richardson at robert@lifopro.com or 531-466-4275
      • Use our online scheduling tool: Schedule Meeting with LIFOPro

Multi-client LIFO Election Scoping Target List

LIFOPro will build a LIFO election scoping target client list for your CPA firm at no cost. Obtaining such a list is extremely effective when your firm would like to implement a firm-wide initiative to integrate LIFO election scoping into year end tax planning. All that’s required is to provide LIFOPro with an Excel file containing the following fields:

• Required fields
  • Unique identifier such as client ID (Client name is not required)
  • Business activity or product description (such as the Primary Business Activity listed on the tax return)
  • Prior year end inventory balance
• Optional fields
  • C or S corporation (used to determine marginal tax rate for calculating tax benefit)
  • Year end month (used to determine appropriate inflation period to use for calculating tax benefit)
  • Prior year end income/loss reported on tax return (used to prioritize top LIFO election candidates)

Sample CPA Firm Multi-client LIFO Election Scoping Target List

Best LIFO Practices: Accounting Methods & Calculation Approaches

There are a variety of LIFO “submethod” alternatives available, and in some cases, there are material differences in the recurring administrative burden & long-term tax benefits amongst the various submethod options. Listed below are the most notable submethod alternatives & LIFOPro’s best practices feedback.

• LIFO value pricing method
  • Specific goods (“unit LIFO”): LIFO value of inventory is accounted for at the item level. Unit costs & the physical flow of goods are tracked on a LIFO basis within accounting system
  • Dollar-value: Under this method, the LIFO value is accounted for as a top-side adjustment rather than at the item level. Unit costs & the physical flow of goods are tracked at actual cost (FIFO, average cost or specific ID) or standard cost. Side computation made outside of accounting system to calculate inflation, layers (decrements), inventory @ LIFO, LIFO reserve & LIFO expense (income)
  • Best practice: Use dollar-value LIFO because it avoids many undesirable characteristics of LIFO & offers materially higher long-term tax benefits when compared to unit LIFO
• LIFO index computation timeframe selection
  • Link-chain: Current quantities are extended against current & prior period item/unit costs to calculate current year inflation index (one year measurement period)
  • Double-extension: Current quantities are extended against current & base period unit costs to calculate current year cumulative index (all years on LIFO measurement period)
  • Best practice: Use Link-chain LIFO because it’s absent of the inherent flaws built into double-extension method & link-chain precludes the need to reconstruct base year costs for new items
• Inflation measurement source
  • Internal indexes: Current year inflation index measured using actual costs paid/incurred to acquire/procure the goods
  • External indexes: aka Inventory Price Index Computation or IPIC method. Bureau of Labor Statistics Consumer/Producer Price Indexes assigned to goods to calculate current year inflation index.
  • Best practice: Common to use the method that’ll provide the most inflation & favorable tax position, but many companies also consider the difference in overall calculation complexity/administrative burden & IRS audit risk when selecting their inflation measurement source (IPIC method is an IRS safe harbor method; internal index is not).
• Pooling method
  • Resellers (retailers & wholesalers/distributors)
    • By line or class of goods
    • Natural business unit can be used in certain cases
    • IPIC pooling method
  • Manufacturers/producers
    • Natural business units (separate pool required for manufactured vs. purchased for resale goods)
    • Raw materials content
    • Multiple pools
    • IPIC pooling method
  • IPIC LIFO method users
    • IPIC Pooling method: pools established for each BLS major group with 5% or more of the total inventory balance at cost
    • Any non-IPIC pooling method listed above that matches your industry type ( i.e., manufacturers using IPIC method could use natural business unit pooling method)
  • Best practices
    • Utilize the method expected to create/require the least amount of LIFO pools to minimize likelihood of LIFO recapture caused by inventory liquidations
    • When possible, use of a single LIFO pool also greatly simplifies performing interim estimates
• Current-year cost method
  • The required starting point used for all dollar-value LIFO calculations is the current year ending inventory value at cost. Accordingly, companies must use a cost flow method in their accounting system that approximates cost. The IRS term for this amount is called the Current-year Cost.
  • The determination of the Current-year cost is a critical step in determining the LIFO inventory value because it is needed to convert or deflate the current year end cost value of inventory to its base year cost, and subsequently inflate the base year cost to the LIFO inventory value.
  • Most companies using LIFO use the dollar-value method because it allows them to continue valuing their inventories within their accounting information system using the same cost flow method they’ve historically used (FIFO, average cost, standard cost, specific identification etc.).
  • The following cost flow methods can be used to determine the Current-year Cost:
    • Latest acquisitions cost (FIFO)
    • Average cost (aka moving/rolling/weighted average cost)
    • Earliest acquisitions cost (“EAC”)
    • Specific identification cost (“Specific ID”)
    • Standard cost (year end adjustment required to adjust to actual cost i.e. average cost or FIFO)
  • Best practices
    • First-time elections: Use the same method employed by accounting system to track item costs prior to electing LIFO to prevent wholesale changes to accounting system or IT burden associated with measuring multiple methods
    • Existing LIFO elections
      • Companies using all methods other than EAC: Continue using existing method
      • Companies currently using EAC
        • Most companies using EAC cost are doing so for LIFO purposes (because EAC creates a bigger LIFO tax benefit than other methods when an increment occurs)
        • Many companies are also using a shortcut to approximate EAC as opposed to maintaining costs at EAC within their accounting system for the following reasons:
          • Maintaining true earliest acquisitions costs within existing accounting information system is difficult or not possible
          • Accounting system uses average EAC is only being used for LIFO purposes
        • Many companies using EAC are actually tracking costs on a FIFO, average cost or standard cost basis in their accounting systems for the following reasons:
          • These methods are compatible with all accounting information systems
          • FIFO, average cost or standard cost provides more accurate information for internal management functions such as purchase/sales forecasts/planning
        • Companies using IPIC method: Change to FIFO, average cost or standard cost because IRS prohibits the use of EAC when using the IPIC method
        • Companies using non-IPIC method: Consider changing to FIFO, average cost or standard cost because it reduces the administrative burden & eliminates IRS audit risk associated with using shortcut to approximate EAC (See Technical Advice Memorandum 9853003 that concludes using an approximation of EAC is impermissible)

Best LIFO Practices: Use of External Indexes (IPIC Method) to Maximize LIFO Tax Benefits

Companies have the option to use one of the two inflation measurement sources to calculate inflation:

• Internal index

  • Uses current quantities double extended against current & prior unit or standard costs
  • Items are defined as the most-detailed record/stockkeeping unit maintained in accounting system
  • Places heavy reliance on accounting information system to maintain detailed inventory listings with reliable, up to date quantities and unit costs

• External index

  • Also known as the IPIC method (Inventory Price Index Computation)
  • Inflation calculated using Bureau of Labor Statistics Consumer/Price Indexes (BLS CPI/PPI)
  • Items are defined as the BLS CPI/PPIs that include the goods on hand
  • Much less reliance placed on accounting system

Why many companies use the IPIC method

• Often creates more inflation & LIFO tax benefits than an internal index inflation for the following reasons:
  • BLS inflation will be greater than internal index inflation on goods that were imported or purchased for resale products sourced from abroad because BLS PPI only measures U.S. or domestic production & domestically produced goods inflation rates have historically been materially higher than imported goods
  • When the IPIC method is used, new items are given preexisting item inflation since BLS only measures price changes on preexisting items (or they reconstruct the cost on any newly-introduced item). With internal indexes, new items’ prior year costs are often set to equal to its current year cost since reconstruction is often burdensome/subjective & IRS Regs. prohibit new items from being excluded from the inflation calculation. As a result, during periods of inflation, new items will reduce the overall current year inflation rate when internal indexes are used. This becomes more pronounced when there’s high item turnover and/or high inflation.
• Can be a quicker, simpler means of performing interim estimates than internal indexes
  • When internal indexes are used, the equivalent of a full year end calculation is required to perform an interim estimate because the current period’s inflation is required to perform interim estimates
  • When external indexes are used, the majority of companies will use last year’s product mix paired against the year to date BLS CPI/PPI inflation rates (or 12 months ended current period) to perform interim estimates
  • Key takeaway: Interim estimates can be performed more quickly when using the IPIC method because it precludes the need to generate a current period inventory report
• Reduce IRS audit risk
  • IPIC method is IRS safe harbor method, which affords taxpayers less scrutiny from IRS upon audit compared to taxpayers using internal indexes since inflation calculation relies on external government indexes & internal indexes rely on the taxpayer’s accounting records/systems
  • Switch to IPIC method from internal indexes to IPIC method provides audit protection from prior period calculation errors
  • Affords audit protection from LIFO reserve overstatements since change is applied beginning in year of change & built from pre-change LIFO reserve
• Simplify LIFO calculation & reduce volatility
  • IPIC method can simplify inflation calculation for manufacturers because:
    • Reduces reliance on accounting information systems & appropriate allocation of item cost components such as materials, labor & overhead since inflation is measured using BLS PPI, not current & prior/base period item/unit costs
    • Inflation for work-in-process inventories are calculated by assigning the applicable finished goods PPI code to the WIP items
  • IPIC method can reduce volatility because BLS surveys thousands of producers & eliminates extreme cost fluctuations that could occur within any single company
• Automatic approval to change to IPIC method & is applied on a cutoff basis
  • Tax deadline for making the change is the extended return filing deadline, meaning change can be made after the year end has closed
  • Change is applied prospectively beginning in the year of change, meaning pre vs. post change LIFO reserve remains the same and no prior period adjustments are made

Accounting for LIFO Errors

When an error or series of errors occur in the LIFO calculation, the corrective actions available and/or required to be made are dependent on the frequency of the error (if the error occurred once or in multiple consecutive periods). Separate GAAP or financial reporting and tax rules also apply when accounting for LIFO errors, which are outlined below.

• Financial reporting LIFO error treatment

  • All LIFO errors should be corrected regardless of if it only occurred once or if it occurred in multiple prior periods
  • Retrospective accounting is required for LIFO errors resulting in a material change
  • Extent of restatement and/or adjustment will likely be dependent on the extent/materiality of the error & the practicability of correcting the error
  • May require for separate book/tax LIFO calculations since error can be corrected for book, but not for tax
  • Best practices:
    • If issuing audited or reviewed GAAP financial reports: If practicable, correct error beginning in the first period that the error is made & apply prior period adjustments to next financial report
    • If not issuing audited or reviewed GAAP financial reports: Follow tax treatment of error

• Tax LIFO error treatment

  • Errors made on two or more consecutive year end tax returns
    • Considered a change in accounting methods: Although permission was not requested by the taxpayer nor granted by the IRS, any LIFO error reported on two or more consecutive period’s tax return is the equivalent of adopting a new LIFO calculation method
    • Error can not be corrected by filing an amended return
      • All LIFO method changes are applied on a cutoff basis (prospective change), meaning the new or proposed method is used beginning in the year of the change
      • Since all LIFO method changes are applied on a cutoff basis, no prior period adjustments to account for the pre vs. post change tax liability is required (§481(a) adjustment not permitted)
    • Automatic consent procedures do not exist to correct LIFO-related errors
      • Most of the automatic LIFO-related accounting method changes relate to changes to or within the IPIC method (external index; using Bureau of Labor Statistics Consumer/Producer Price Index)
      • The LIFO error will remain locked in place even if a LIFO-related accounting method change is made because all LIFO accounting method changes are applied on a cutoff basis
  • Best Practices
    • Internal index: Switch to the IPIC method if an internal index is presently used
      • IPIC method is an IRS safe harbor method. This means upon changing to the IPIC method, taxpayers receive audit protection from all prior period LIFO errors, LIFO-related taxable income overstatement/understatements
      • Ideal when error(s) resulted in a LIFO reserve overstatement & tax liability understatement since audit protection precludes IRS from proposing unfavorable adjustment
      • Automatic approval to switch to the IPIC method & requires no IRS users fee (only requires an IRS Form 3115/970 to be filed)
      • Change can be made after the close of the year end and the Form 3115/970 filing deadline is the same as the extended return filing date
      • Change to the IPIC method is made on a cutoff basis i.e. prospective change applied beginning in the year of change, so no prior period adjustments are required nor permitted (IRS requires layer rebasing, but this does not affect the LIFO reserve)
    • Make a change within the IPIC method if the IPIC
    • Automatic change procedures apply for change to the IPIC method
      • Change can be made after the close of the year end and the filing deadline is the same as the extended return filing date
      • Change to the IPIC method is made on a cutoff basis (prospective change applied beginning in the year of change), so no prior period adjustments are permitted
      • Ideal when error(s) resulted in a LIFO reserve overstatement & tax liability understatement since audit protection precludes IRS from proposing unfavorable adjustment
  • One-time errors
    • Are NOT considered a change in accounting method
    • Some companies choose to correct the error immediately upon discovery by applying the correction to the LIFO calculation for the next period to be closed & running the error through the next tax return to be filed
    • Best practice: Can & should be corrected by filing an amended tax return if the error is discovered by or before the later of 1. Within three years from the original filing date of the return that included the error 2. Two years from the date the tax liability for that return that included the error was paid.

Complimentary Offerings

Get top-notch complimentary analysis & review from the LIFO experts. LIFOPro offers Best LIFO Practices & Methods Reviews for companies on LIFO. We also provide LIFO Election Benefit Analysis for companies considering adopting LIFO. Companies seeking an automated LIFO solution or replacement to their current LIFO system can get a free software trial.

LIFO Election Benefit Analysis

• Companies receive a comprehensive report that establishes whether or not LIFO is preferable, estimates the historical & election year LIFO tax benefit, includes election timing & submethods recommendations, provides the amount to record a LIFO journal entry & prepare financial reports/statements on a LIFO basis & includes a How LIFO Works Guide
• Also included is LIFOPro’s outsourcing solutions fee quote

Best LIFO Practices & Review

• Companies receive a comprehensive report that confirms LIFO calculation accuracy (or identifies errors & provides comparisons between as filed vs. as corrected), identifies LIFO tax benefit maximization strategies (and provides comparisons between the proposed vs. present methods) & offers recommendations regarding potential changes, error corrections, how to eliminate IRS audit risk & how to simplify calculation procedures
• Companies receive a LIFOPro report package that ties to their most recently calculated LIFO reserve
• Also included is LIFOPro’s outsourcing solutions fee quote

Document Requirements

• LIFO election benefit analysis (for clients not on LIFO)
  • Non auto dealers:
    • Current & prior period’s item detail reports
    • Completed LIFO election benefit analysis questionnaire
  • Auto dealers
    • Invoices for all vehicles on hand as of current period & as of prior year end
    • Completed auto dealer LIFO election benefit analysis questionnaire
• Best practice & review (for clients already using LIFO): Prior two period’s LIFO calculation documentation

Sample Best Practices & Review Report Excerpt #1

Sample Best Practices & Review Report Excerpt #2

Sample Best Practices & Review Report Excerpt #3

Sample Best Practices & Review Report Excerpt #4

LIFOPro makes being on LIFO as simple as possible. We act as a third party LIFO service provider & subject matter expert to both CPA firms & companies. We design customized solutions that fit your firm & client’s LIFO needs, not a one-size fits all solution that offers more or less than what is needed. Our powerful in-house developed/maintained software allows us to automate most aspects of the work, spend a fraction of the time required by anyone else making manual LIFO calculations & deliver high-quality solutions at the most reasonable costs. We work with companies of all sizes and situations, including companies already on LIFO or those that aren’t but are considering a LIFO election.

LIFOPro Outsourcing Engagement Overview

LIFOPro’s Responsibilities

• Preparing all aspects of the LIFO calculation & supporting documentation free of errors and in accordance with IRS Regs., including
  • Inflation calculation (including BLS category assignments for companies using the IPIC method)
  • Layer calculations
  • LIFO inventory value, LIFO reserve & LIFO reserve change calculations
• Prepare documentation (LIFOPro reports) that provide adequate books & records of the LIFO inventory value & all supporting computations
• Deliver LIFOPro report package that includes all amounts required for the client to complete the following:
  • Record this year’s LIFO journal entry which will adjust the year end inventory balance to its LIFO value
  • Prepare the year end annual financial report/statement on a LIFO basis
  • Prepare year end tax return on a LIFO basis
  • Net inventory method adjustments (if applicable; for auto dealers using net inventory method)
• Interim LIFO estimate preparation & delivery (if applicable)
• Preparing the book vs. tax LIFO Schedule M tax return entry value (if applicable)
• Preparing the §263A UNICAP cost Schedule M entry value (if applicable; using the client-provided absorption ratio)
• Preparing IRS forms & statements related to LIFO elections or accounting method changes (if applicable)
• Preparing supporting documentation related to any pro forma LIFO calculations, reviews or accounting method changes (if applicable)
• Up to 40 hours of audit support related to the services provided by LIFOPro

CPA Firm or Client Responsibilities

• Prepare & furnish the documents required by LIFOPro to complete our services
• Review LIFOPro report package and confirm all applicable amounts match the client’s books and records
• Record the annual LIFO adjusting journal entry
• Prepare the tax return on a LIFO basis
• Prepare annual financial reports/statements on a LIFO basis
• Notify LIFOPro of any LIFOPro report discrepancies discovered by the client or notify LIFOPro of adjustments made after LIFOPro report delivery that would affect the accuracy of the client’s LIFO inventory value (if applicable)
• Attach IRS forms & statements related to LIFO elections or LIFO accounting method changes to the tax return (if applicable)