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LIFO Method: What is LIFO?

01/06/2019

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LIFO, which stands for "last-in, first-out," is an inventory valuation method used only by U.S. companies with IRS approval and is an established tax method that has been a part of the U.S. tax law for over 80 years. It is used by thousands of companies, including automotive dealerships for inventory management and tax planning purposes.

You have choices when it comes to reporting inventory costs. The LIFO method is a popular technique that assumes your merchandise is sold in the reverse order it was acquired or produced. That is, it allocates the most recent costs to the cost of sales. Although this method is often preferred for tax purposes, internal accounting personnel may be hesitant to use it for various reasons.

The LIFO Method

The LIFO method assumes that the last items placed into a company’s inventory are the first items sold. LIFO uses the most recent cost of vehicles manufactured to value the inventory at the end of an accounting period. LIFO calculations result in recording a LIFO reserve that will yield a lower value of ending inventory at the accounting date compared to the first-in, first-out (FIFO) method and would reduce taxable income by an amount equal to the change in the reserve account at the accounting date. Therefore, the LIFO method may be very advantageous to auto dealers.

The IRS summarizes the LIFO method as, “available to any automobile dealer engaged in the business of retail sales of new automobiles or new light-duty trucks for its LIFO inventories of new automobiles and new light-duty trucks. Light-duty trucks are trucks with a gross vehicle weight of 14,000 pounds or less, which are also referred to as class 1, 2, or 3 trucks.”*

Tax Benefits

Assuming your inventory costs generally increase over time, LIFO offers a definite tax advantage over other inventory reporting methods. By allocating the most recent — and, therefore, higher — costs first, LIFO maximizes your cost of goods sold, which minimizes your taxable income.

In contrast, the first-in, first-out (FIFO) method assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices.

Financial Reporting Challenges

Before you jump headfirst into using LIFO, it’s important to recognize that it’s not permitted under International Financial Reporting Standards. The approach also involves sophisticated record keeping and calculations.

For example, the “LIFO conformity rule” generally requires you to use the same inventory accounting method for tax and financial statement purposes. Switching to LIFO may reduce your tax bill, but it could also depress your current earnings and reduce the value of inventories on your balance sheet, thus giving the appearance of a weaker financial position.

LIFO also can create a problem if your inventory levels are declining. As higher inventory costs are used up, you’ll need to start dipping into lower-cost “layers” of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed you to defer.

Moreover, if a C corporation elects S corporation status, the business must include a “LIFO recapture amount” in income for the C corporation’s last tax year. The recapture amount is the excess of your inventory’s value using FIFO over its value using LIFO. Fortunately, you can spread out the tax payments over four years in equal, interest-free installments.

One of the biggest challenges in using LIFO is the need to measure changes in inventory costs. If you currently use LIFO, you may be able to enjoy additional savings by electing to use the inventory price index computation method. It may enable you to reduce administrative costs — and it might even generate greater tax benefits — if you rely on government indexes to calculate LIFO values rather than developing an internal index.

LIFO Calculation Software

LBMC LIFO Solutions, LLC, offers an affordable, easy-to-use LIFO calculation software for auto dealers and CPA firms with auto dealer clients. The software offers databases for those who inventory new and/or used vehicles utilizing Microsoft Excel® to report the results.

If you have questions about the LIFO method or our software, feel free to contact LBMC at 615-377-4600 to speak with a representative or use the contact form on this page.

Download Free Demo of LIFO Software LBMC LIFO Solutions, LLC, offers a FREE LIFO software demo that you can download here.

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We are here to answer any questions you may have about our software or provide you with an estimate.

* IRS: Alternative LIFO for Auto Dealers