ARTICLE | February 18th, 2025

A company’s most valuable asset is inventory, but it can also be the most significant line item on a balance sheet. The LIFO method of accounting can provide a valuable means of generating cash by leveraging a company’s existing inventory for profit.

How it works

LIFO is an acronym for Last In, First Out. It describes a method of accounting based on the belief that newly purchased inventory is sold ahead of that which was bought earlier. During periods of rising inflation, the theory is that higher priced inventory will be sold and distributed while the earlier and lower priced products will be part of the ending inventory.

The LIFO method has no bearing on the actual distribution of product, this is only a cash flow method for accounting.

LIFO and FIFO

FIFO (First in, First Out) assumes the first inventory bought are the first sold and removed. During inflation, the FIFO accounting approach will lead to higher values on ending inventory as opposed to the LIFO approach with more cost capitalization on inventory but lower tax savings benefits.

This makes LIFO a more advantageous method, particularly as prices rise, because it places a lower value on remaining inventory which equals a higher cost of Goods Sold. That can have a direct effect on reducing a company’s taxable income and the amount of tax owed for the year.

LIFO Reserves

A LIFO Reserve describes the contrast of inventory value between the LIFO and FIFO inventory methods and demonstrates the cumulative tax benefit of using the LIFO approach. While many businesses will employ FIFO as a means to monitor the status of inventory, it’s the LIFO approach that is most often chosen for reporting income. When inflation is rising, a company’s LIFO Reserve will increase from one year to the next.

LIFO Example

Company X buys and sells just one product. At the start of the year, the cost to buy the product is $10. The product is then bought and sold multiple times over the course of the year with a year-end purchase cost of $12.

If Company X had just one of these products in the start of year and end of year inventory, LIFO would yield a tax benefit of $2 which is the difference in the FIFO value ($12) and LIFO value ($10). Therefore, Company X would be granted an added $2 deduction. This additional deduction would decrease taxable income, creating a $2 tax benefit.

Taking the next year into consideration under the same conditions but with the last purchase price of $15, the year 2 benefit for Company X would be $5 which breaks down to a $15 FIFO value less the LIFO value of $10. This would result in an added deduction of $3 – the difference between the cumulative LIFO benefits of this and the previous year.

Who is a good fit?

Any industry that faces rising costs can benefit from using the LIFO method of accounting.

Taking Advantage of the LIFO Method of Accounting

In order to use LIFO, a company must formally elect to do so through filing form 970 – Application to use LIFO Inventory Method. Additionally, should a company wish to make any changes to the accounting method, you must do so on Form 3115 – Application for Change in Accounting Method.

The Form 3115 is automatically accepted for a 5-year term. After 5 years, the election expires. If you would like to opt of before the 5-year term, there is a possibility to opt out although it is not an automatic opt out. You would be required to pay the IRS $11,500 to opt out.

For more information about the LIFO method of accounting, call us today at (360) 734-4280.

FAQs

My inventory turns over at a fast rate. Is this worth it for me?

Yes, it is worth it. It does not matter how many times inventory turns over; you would still get benefit. The LIFO adjustment looks at the change in inflation from the beginning of the year to the end of the year. Some of the largest users of the LIFO studies are grocery stores, who experience extremely high inventory turnover.

What is the day-to-day impact of electing the LIFO method of accounting?

You should have little to no day-to-day impact. We would need to get a detailed listing of inventory for current year end and prior year end. You will be provided a journal entry at the end of the year to record the LIFO reserve.

What happens if inventory value or volume drops?

As your LIFO study is being prepared, it will be evaluated annually and recommend a time to elect out, if necessary.

My goal is to eventually sell the business, how will electing the LIFO method effect the sale of my business?

Depending on the entity type, and the structure of the sale, the LIFO method can have some effect on the basis in your inventory on the books. If you are interested in exploring this more, let us know and we can have a more in-depth conversation that pertains to your situation