Did you know that the last-in, first-out (LIFO) method could help private companies manage high inventory costs?
August 26, 2022
Inflation is abnormally high across most sectors compared to the last few decades. Annual inflation for all commodities is 17.5% as of July 2022, with the top industries impacted being fuels and related products (41%), farm products (27.1%), rubber and plastic products (16.8%), and textile products and apparel (14.1%). These levels of increased cost are leaving many companies looking for ways to conserve cash and capital in other areas.
Using last-in, first-out (LIFO) to manage high inventory costs
One way to potentially conserve cash is to look for tax savings related to inventory costs. Any company that maintains inventory is required to identify that inventory under a permissible method such as specific identification, first-in, first-out (FIFO), or LIFO. Our current economic conditions—including higher inflation and higher pricing—offer the possibility for cash tax savings for private companies with significant inventory levels by exploring the adoption of the LIFO method of accounting or considering changes to your current LIFO method.
The benefits of LIFO during inflationary times
Under the LIFO method, the goods most recently produced or acquired are deemed to be sold first. Thus, when costs are rising, LIFO generally results in higher cost of goods sold and lower taxable income. If inflation continues and inventory quantities stay consistent or increase, companies using LIFO will immediately, and in future years, experience a cash tax benefit.
The above example of LIFO calculation shows how a LIFO reserve could grow during inflationary times and beyond.
The impact of increasing inventory balances
We’ve seen private companies stocking up on inventory to beat rising inflation and combat supply chain issues. The downside to having excess inventory on-hand is that it could lead to higher costs for handling and storing inventory as well as less available capital. With rising interest rates, the cost of capital is also increasingly leading companies to look for alternative sources. Companies that are not using LIFO should consider adopting the LIFO method for their inventory to reduce taxable income and their cash tax outlay.
An opportunity for private companies
To be eligible to use LIFO for tax purposes, there is a book conformity requirement. The book conformity rule provides that the LIFO method of accounting for inventory must be used for financial reporting purposes for it to be adopted for tax purposes. The LIFO method of accounting generally increases cost of sales relating to inventory sales and generally reduces net income, so some companies that report earnings publicly are reluctant to utilize the LIFO method for inventory. Because private companies often limit the distribution of their financial statements and are not typically measured on metrics such as earnings per share, this requirement is not as challenging to overcome when compared to the resulting cash tax savings.
Exception to the book conformity rule
As an exception to the book conformity rule, if a US company is a member of a foreign consolidated group in which worldwide foreign operating assets are at least 30% of the total operating assets, the conformity requirement will be deemed to have been met if the US company issues LIFO financial statements to its foreign parent, even though the foreign parent issues its financial statements using a non-LIFO method consistent with IFRS.
Timing is important
Nimble private companies have the ability to adjust their strategies quickly and can take advantage of the opportunities that exist in the current economic environment. Because of the book conformity requirement, companies should begin discussions immediately to assess whether LIFO can be adopted for financial reporting. As time will be needed to assess both the book and tax methodologies and calculations, the earlier these decisions can be made, the better to ensure proper presentation in 2022 financial statements.
Stay informed
Browse our Private Company Perspectives collection for insights and evolving trends for private companies.
Follow us
