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.
