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Understanding Last In, First Out (LIFO) and Your Balance Sheet

1. Cost Flow Assumptions. For the inventory you sell, you must use a cash flow method to assign costs. To calculate gross profit, you subtract the cost of goods sold (COGS) from sales revenue. Your COGS, gross profit, net profit and taxes due are all set by your choice of cash flow method. Normally, prices rise over time, and you will find the last in, first out (LIFO) method very useful.Your COGS will contain the latest and highest costs when you choose the LIFO method. This is exactly what you want, because it results in the lowest taxable income and the lowest taxes paid.  You would achieve the opposite effect -- your taxable income would be greater -- if you chose the first in, first out (FIFO) method.  The nice thing is that you can use FIFO for financial reporting to show investors higher income and use LIFO on your tax returns to minimize taxes. To track inventory costs, you may choose from several specialized variations of the LIFO method. You use these various methods to create pools of inventory grouped by physical characteristics or simply by year of purchase. All methods end up creating layers of inventory with different costs. LIFO liquidation happens when you exhaust the supply of your latest inventory costs and must dip into older layers. LIFO liquidation is something you normally want to avoid because it decreases your COGS and escalates your taxable income. However, there are times when liquidation is unavoidable, as when some merchandise you stock becomes discontinued. Eventually, as you sell off your remaining stock, you will run through all of your LIFO layers. A few examples of the various LIFO methods are below:a)   Dollar Value LIFO. In this method, you eliminate the effects of inflation on your LIFO pools by dividing by a price index provided by the federal government. This way, you compare your beginning and ending inventory costs without the distortions caused by inflation. If the real value of inventory decreases over the course of the year, you have experienced a LIFO liquidation. On the other hand, if real inventory cost increases, you have created a new LIFO layer. b)   Simplified Dollar-Value LIFO. You might instead choose the simplified dollar-value LIFO method if your business is small enough. To qualify, your average annual gross receipts cannot exceed $5 million over the past three years. The simplification in the method involves how you group your inventory into pools. Government price indexes contain a lot of categories -- you choose the ones that match the inventory you carry and apply the annual changes in the appropriate deflator indexes to the different pools. For example, if you sell men’s clothing, you would use the men’s and boy’s apparel category from the Consumer Price Index to adjust your inventory cost. c)   LIFO Reserve. LIFO reserve, often called “excess of FIFO over LIFO”, is the difference of your inventory’s book value under the two assumptions. For you accounting types, the LIFO reserve account is a contra-asset account tied to inventory. The balance in the account shows the cumulative effect of switching from FIFO to LIFO for tax reporting; going all the way back to when you first adopted LIFO. Under normal circumstances, like rising prices, the reserve account will reflect the lower value of inventory under LIFO by having a credit balance. COGS reflects the change in the LIFO reserve account from year to year. At times, investors examine your LIFO reserve to see how you stack up against a company using FIFO for tax reporting.
2. Your Balance Sheet. The inventory equation states that when you subtract your COGS from your beginning inventory plus purchases, you get the cost of your ending inventory. This is the number you carry on the balance sheet. The value of your balance sheet inventory increases as you lower your COGS by liquidating LIFO inventory. The side effect is a higher level of working capital and current assets. You might want to disclose the effect of LIFO liquidation on your COGS in your financial reporting. You can compare the figures with the ones you would have gotten had you been able to avoid LIFO liquidation.