Is a Change From FIFO to LIFO Prospective or Retrospective?
Explore the specific accounting guidance for changing to the LIFO inventory method, which diverges from the standard approach for accounting principle changes.
Companies periodically evaluate their accounting methods, and a frequent consideration is changing inventory valuation from the First-In, First-Out (FIFO) method to the Last-In, First-Out (LIFO) method. This decision has significant financial and tax reporting implications. Accounting standards govern this change and dictate whether it must be reported by restating past results or only applying it to future periods.
Classifying the Change in Accounting Principle
A switch from FIFO to LIFO is categorized as a change in accounting principle under U.S. Generally Accepted Accounting Principles (GAAP). The framework for these changes is provided by Accounting Standards Codification (ASC) 250. The default rule is that a voluntary change in accounting principle must be applied retrospectively, meaning the company must adjust the financial statements of all prior periods presented as if the new method had been in use all along.
This process requires adjusting the opening balance of retained earnings for the earliest period presented to show the cumulative effect of the change. The goal is to enhance the consistency and comparability of financial information across different time periods.
The Impracticability Exception for LIFO Adoption
The change from FIFO to LIFO is a notable exception to the general rule of retrospective application. This specific change is accounted for prospectively, meaning it is applied from the beginning of the period in which the change is made, with no restatement of prior financial statements. The justification for this departure is the concept of “impracticability” as described within ASC 250.
Applying LIFO retrospectively would require a company to reconstruct historical inventory layers, often going back many years. This is considered impracticable because it would necessitate determining specific costs and quantities for each historical layer, which is often impossible due to unavailable or incomplete records. Such an exercise would be prohibitively expensive and time-consuming, and the resulting financials would be based on unreliable estimates. Due to this impracticability, the carrying value of inventory under the old FIFO method at the close of the prior period serves as the initial “base-year” layer for the new LIFO method.
Financial Statement Application and Disclosures
When a company changes from FIFO to LIFO, the carrying value of the inventory under FIFO at the end of the preceding fiscal year becomes the cost of the initial LIFO layer. This amount is carried forward as the first layer in the new LIFO inventory calculation. The company must also provide extensive footnote disclosures in its financial statements for the period of the change.
The notes must explain the nature of the change in accounting principle and the justification for it, including why the new LIFO method is considered preferable. A key disclosure is a statement explaining why retrospective application was deemed impracticable. The company must also disclose the effect of the change on the current period’s income from continuing operations, net income, and the related per-share amounts.
Tax Reporting Requirements for the Change
Switching to LIFO has distinct tax compliance requirements. To change its accounting method for tax purposes, a business must file Form 3115, Application for Change in Accounting Method. This is an automatic change procedure that does not require advance IRS consent or a user fee, as long as the form is filed with a timely tax return for the year the change is made.
A significant tax consideration is the LIFO conformity rule. This rule mandates that if a company uses the LIFO method for tax purposes, it must also use the LIFO method for its primary financial reports to shareholders and creditors. A company cannot use LIFO on its tax return to report lower taxable income during inflationary periods while using FIFO on its financial statements to report higher profits. This rule forces companies to weigh the benefits of tax deferral against the impact of reporting lower earnings on their financial statements.