By: Randy Mahoney, Senior Manager

Mention the acronym LIFO at many businesses, and you are likely to get reactions ranging from a blank stare to those you might see when someone has eaten sun-baked seafood pasta salad at their church picnic.  Historically, the use of the LIFO inventory valuation method has been complicated and an administrative nightmare.  Although there may have been benefits to utilizing LIFO, many management teams have chosen not to test the waters because of the complexities and the unknown impact to the bottom line.  The inflationary economic environment and simplifications to the computation allowed by the IRS in recent years have made LIFO worth a second look.

What is LIFO?

The LIFO (Last-In, First-Out) inventory valuation method assumes the last inventory purchases during a period were sold first, leaving remaining inventory on the balance sheet at earlier prices.  For example, assume ten widgets were purchased on January 1, 2004, for $8 and five were purchased on December 1, 2004, for $10.  During 2004, seven widgets were sold.  The LIFO inventory on the balance sheet would be valued at $64 (eight widgets remaining at $8 per unit).  On the income statement side, cost of sales for 2004 would be $66 (five widgets sold at $10 plus two widgets sold at $8).  The FIFO (First-In, First-Out) inventory valuation method used by many companies would have resulted in an ending inventory of $74 (five widgets remaining at $10 per unit plus three at $8 per unit) and cost of sales of $56 (seven widgets sold at $8 per unit).

As you can see in the example above, in an inflationary environment, the use of the LIFO method results in a lower ending inventory and higher cost of sales figure for the year.  This also results in a lower income tax bill for 2004.

Turn Inflation Into an Asset

Every business is facing the reality of inflation in 2004.  Fuel, steel, concrete, lumber, and other commodity prices are soaring.  The rising prices have led to higher costs for inventories.  In some cases, the inflation on individual items has been in excess of 20 percent.  Unless companies have the ability to pass on these increases to their customers, profitability suffers.

Typically, inflation is detrimental, but it can be an instrumental tool in minimizing taxable income when using the LIFO method.  This is particularly true during periods when inventories are rising and there are steady increases in inflation.  It allows producers and distributors to record inventories at lower costs and defers some of the income tax burden.

Simplification of Process

In January 2002, the IRS finalized regulations on the utilization of the LIFO inventory method.  The new taxpayer-friendly regulations made the IPIC (Inventory Price Index Computation) LIFO approach more attractive for many companies.  The IPIC LIFO method utilizes indices published on a monthly basis by the U.S. Bureau of Labor Statistics.  Inflation or deflation of categories of inventories is based upon the changes in the indices during a period.  The IPIC method provides many benefits, including:

• Decrease in administrative burden when compared to the Link Chain method or Double Extension method.
• Higher degree of predictability for year-end adjustments.
• Taxpayers can select the month that is the base for the calculation.  This means a month prior to year-end can be selected allowing quick computation after year-end.
• Interim computations are relatively easy to complete using the monthly information compiled by the U.S. Bureau of Labor Statistics.

In conclusion, there could be significant income tax deferral opportunities for companies that adopt the LIFO inventory valuation method in 2004.  The new IPIC LIFO rules greatly simplify the process and might be enough to change your opinion of this “four-letter word.”