Publications

• 30 Second Ideas
• Accounting Updates
• Alerts
• Articles
• Business Surveys
• Construction Edge
• Healthcare Edge
• Insurance Edge
• Legal Talent
• Manufacturing Edge
• Not-for-Profit Edge
• Quick Links & Good Ideas
• SEC Edge
• Strategy Insights Blog
• Surviving the Upturn
• Tax Highlights

Article Author:

LIFO and Decreasing Prices—The Perfect Storm?

Many manufacturers and distributors will default to utilizing the first-in, first-out (FIFO) method in valuing inventory. When raw material and product prices are increasing, older inventory items are replaced with new, higher priced inventory as products are sold. This method causes the higher priced, recently purchased inventory to remain on the balance sheet while the lower cost of older inventory is matched against sales revenue as cost of goods sold.

Alternatively, some taxpayers elect to use a different method of inventory costing known as LIFO (last-in, first-out). During periods of rising prices, LIFO allocates the newer, more expensive inventory items to the taxpayer’s cost of sales (thus, reducing taxable income). Under LIFO, inventory value is based on costs from the oldest purchases, which could be from decades-old pricing. From an income tax perspective, the goal is to expense higher, current year inventory costs and keep older (and probably lower) prior year costs in inventory.

LIFO When Prices Fall

When prices are falling, LIFO reverses itself. Higher costs are expensed and lower costs are added to inventory. This results in a decrease in your “LIFO Reserve.” A LIFO Reserve is the cumulative difference between maintaining inventory using LIFO versus FIFO. For some of our clients, this difference exceeds $25 million. Your LIFO Reserve is essentially the amount of taxable income that can be deferred by electing the LIFO method.

Toward the end of 2008, prices for many commodities dropped dramatically. Many clients saw a rapid decrease in the cost of raw materials or in the cost of inventory purchased. In 2009, price deflation continued in some cases or, in many cases, prices stayed fairly constant. Because of timing and the vagaries of various LIFO calculation methods, many companies did not see their LIFO Reserve decrease in 2008, and some even saw increases. This year, however, many companies are experiencing the full impact of price deflation manifested in significant LIFO Reserve reversals. Recognizing that some reversal of your LIFO Reserve might be unavoidable in 2009, the following ideas could help mitigate the damage.

Using the Inventory Price Index Computation (IPIC) LIFO Method

Review of Index Month

All IPIC method taxpayers, other than retailers, must choose an appropriate month for purposes of computing the LIFO index when changing to this inventory method. Many taxpayers have defaulted to using the same month each year or simply use their year-end. If you chose to use an appropriate month for computing the LIFO index, you might be able to choose a different, more appropriate month this year or even annually. This could render a less dramatic impact on your LIFO Reserve.

Due to fluctuations in pricing, you might be eligible for a tax benefit for changing the month you use for calculating your inventory under IPIC. Keep in mind that there are very specific rules to follow regarding this election. Changing the “appropriate month” determination might be considered a change in accounting method, requiring additional filings with your tax return as well as IRS approval.

Review of Pools

IPIC method taxpayers determine their LIFO indexes using information published by the U.S. Bureau of Labor Statistics (BLS). Oftentimes, we find that companies are not using the appropriate BLS categories or are not dividing their inventory into all of its components. Categorizing inventory in this way sometimes allows you to take advantage of more favorable BLS categories. A detailed review of a company’s IPIC method LIFO calculation with a focus on whether the appropriate BLS categories are being used could result in a more accurate and beneficial LIFO result.

General LIFO Planning

Here are a few other items to consider.

• Would choosing an alternative LIFO valuation method be appropriate and tax-effective? Some changes in LIFO valuation methods are automatic changes that do not require prior IRS approval.
• Would it make sense to switch off of LIFO? For taxpayers with large net operating losses, the burden of picking up the LIFO reserve into income (over a four-year period) might be sheltered by losses. If you switch off of LIFO, you will not be able to re-elect LIFO for five years. Also, by switching off of LIFO you might be able to take advantage of inventory write-downs under the lower of cost or market inventory method.
• Does it make good business sense to build up inventory levels to manage the burden of a current year LIFO income pickup?

Any of the above items must be considered in the context of long-term planning and what’s best for your business. Therefore, careful consideration should be given to any decision regarding LIFO.

GAAPUSA vs. Tax Accounting

• Under GAAPUSA, the total accumulated LIFO reserve cannot be negative. For tax purposes, the accumulated LIFO reserve can go negative. Companies must be aware of the timing difference implications of this matter when computing tax liabilities.
• Under GAAPUSA, there might still be a lower of cost or market adjustment even when utilizing LIFO. For tax purposes, there is no such adjustment under LIFO rules.

If either of these situations exist, the taxpayer might want to consider reverting back to the FIFO inventory method.

Questions about LIFO?
Contact Mike Calahan at 312-980-2996 or Cara Hoffman at 312-980-3274.




 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.