The consumer price index (CPI) climbed 7 percent in 2021, the largest 12-month gain since June 1982, according to data released by the U.S Labor Department. Core prices, which exclude more volatile food and energy products, rose 5.5 percent from a year earlier. Many economists are predicting that CPI growth will continue in 2022 but may moderate, perhaps to roughly 3 percent.
However, these economic forecasts depend on the resolution of supply chain bottlenecks, moderation in energy prices, and a variety of other potential political and economic factors. If these events don’t occur, it could result in continued inflationary trends.
If your company is a manufacturer or distributor facing the impact of inflation, the time may be at hand to consider an accounting method that potentially helps “turn lemons into lemonade” – the LIFO (last-in, first-out) inventory method.
Advantages of the LIFO Method
Better match recent costs against current revenues
The LIFO method can provide a more accurate measurement of current earnings by matching most recent costs to current revenues. FIFO (first-in, first-out) and other non-LIFO methods can lead to distortions by matching old costs to current revenues.
During inflationary periods, artificial profit can result from simply carrying inventory, which can understate the cost of replacement of the goods sold. This, in turn, can distort measurement of the company’s ability to continue to generate such profit.
LIFO can mitigate the distortive impact of “inventory profit” by matching the most recent costs against revenues. The company’s ability to continue with a comparable quality and reliability of the reported earnings is arguably more clearly measured under LIFO.
Improve cash flows resulting from LIFO income tax benefits
One of the primary benefits of using LIFO during an inflationary period is the associated income tax benefit. Matching current rising higher prices against revenues alleviates “inventory profit,” lowers taxable income, and reduces income tax expense. The reduction in income tax expense results in an improvement of the company’s cash flows. LIFO can be viewed as a loan equal to the deferred income tax liability for which there is no interest charge, assuming tax rates remain stable.
Example: A company historically carries inventory valued at $5 million costed under a non-LIFO method. The annual inflation rate utilized in LIFO inventory costing is 6 percent. Using LIFO could result in a $300,000 reduction in taxable income, which at an effective Federal tax rate of 30 percent could yield a $90,000 reduction in current income tax expense.
If the inflation rate in the next year continues at 6 percent and the level of inventory remains steady, a further $318,000 reduction of taxable income (another $300,000 increment plus $18,000 build-up in the first year increment) could arise in that year, resulting in an additional roughly $95,000 tax deferral. This translates to a cumulative tax deferral of $185,000 after the first two years.
Minimize the need for write-downs due to temporary market pricing fluctuations
The net income of a company that uses LIFO is less likely to be affected by a temporary decline in market prices. The reason: a company using the LIFO method will be less likely to have significant components of inventory reported at most recent prices, as recently acquired inventory will be considered to have been sold first. This reduces the potential for market write-downs as the implications of a temporary price decline are minimized under LIFO.
Disadvantages of the LIFO Method
Reduced earnings during inflationary times and potential financial covenant implications
One of the requirements of using LIFO for tax purposes is that no other method can be used to value inventory when calculating income, profit, or loss for the same tax year in any report or statement provided to shareholders, other owners, or creditors. This is the so-called “conformity rule,” meaning that companies will also need to adopt LIFO for financial reporting under U.S. GAAP. The LIFO method will reduce the level of reported earnings during periods of inflation, and the income tax benefit may be viewed as a potential financial reporting disadvantage.
In order to make an accounting policy change under U.S. GAAP, such as a change from FIFO to LIFO, the company must demonstrate that the new policy is preferable. This may be achievable based on the impact an inflationary environment has on a company’s balance sheet and operations.
Some business owners may be concerned that the use of LIFO will have a potentially negative impact on creditors and investors. A common financial covenant many companies have with their lender is a debt service coverage ratio, which identifies whether a company’s earnings are sufficient to meet future debt service obligations. Under the LIFO method, a company’s EBITDA will likely decrease, which may trip the debt service covenant. LIFO adoption may also reduce the perception of the company’s value because these parties may not fully understand LIFO or take the time to normalize its implications when carrying out their financial analysis.
Negative impact on reported level of working capital
The financial statement balance sheet value of inventory will be lower under LIFO than under other costing methods; therefore, the company’s working capital position can be negatively impacted. However, the beneficial implications relating to current income tax expense can soften some of this impact.
Potential impact of untimely LIFO liquidations
A material inventory liquidation event may result in an inflated level of reported income in the period when this event occurs, resulting in higher income tax payments at some point in the future. If tax rates increase over time, the tax deferral during the period LIFO has been used would potentially be paid back at a higher level than the initial savings, resulting in the equivalent of an interest charge on the tax deferral.
A tax repayment from a LIFO liquidation event may occur when a company experiences business activity related stress, compounding its economic issues. To avoid this problem, a company may look to purchase goods in larger quantities at year-end than business operations require. Adopting LIFO may, thereby, lead to the development of poor inventory management practices.
An important takeaway is that LIFO does not involve a change in basic business operational strategy, but rather, represents a method for presenting cost flows arising from acquiring and producing goods for sale to customers. During a period of inflation, LIFO more heavily assigns most recent costs to sales. From an income tax perspective, this can materially lower taxable profit and thereby reduce current tax payments.
For more information, or for assistance in determining whether now is an appropriate time to adopt LIFO for your business, please contact your Kreischer Miller relationship professional or any member of our Tax Strategies team.
Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.