Is LIFO Allowed Under GAAP for Inventory Accounting?

Inventory accounting methods impact financial statements and tax obligations, making the choice between FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) significant for businesses. The method selected influences reported profits, inventory valuation, and tax liabilities, particularly during inflation when costs rise.

LIFO Under GAAP

LIFO is an accepted inventory valuation method under U.S. Generally Accepted Accounting Principles (GAAP), allowing companies to account for inventory costs based on recent price changes. It assumes the most recently acquired inventory is sold first, which can lower reported earnings when costs rise. Unlike International Financial Reporting Standards (IFRS), which prohibit LIFO, GAAP permits its use, making it an option for U.S.-based companies.

Industries with frequent inventory cost fluctuations, such as oil and gas, retail, and manufacturing, often use LIFO to align current costs with current revenues. This approach can reduce taxable income during inflationary periods, improving cash flow. However, it also means older inventory remains on the balance sheet at outdated costs, potentially understating inventory value.

LIFO affects financial ratios used by investors and analysts. Lower net income results in a higher price-to-earnings (P/E) ratio, making a company appear less profitable than competitors using FIFO. Additionally, lower inventory valuation can impact the current ratio, a measure of liquidity, making a company seem less financially stable than it actually is.

LIFO Conformity Requirement

Companies using LIFO for tax purposes must also apply it in their financial statements, a rule mandated by the Internal Revenue Code (IRC) 472(c). This prevents businesses from lowering taxable income with LIFO while using a different method, such as FIFO, to present stronger financial results to investors.

The rule applies to financial statements provided to shareholders, creditors, or regulators, including annual reports and SEC filings. If a company were to use LIFO for tax filings but FIFO for external reporting, it could mislead stakeholders about earnings and financial health. The IRS enforces this requirement to ensure consistency.

There are exceptions. Companies can provide supplemental disclosures with non-LIFO financial data as long as the primary financial statements follow LIFO. Non-GAAP measures, such as earnings before interest, taxes, depreciation, and amortization (EBITDA), can also be presented without LIFO adjustments if properly reconciled to GAAP figures.

Disclosure and Reporting

Public companies using LIFO must comply with disclosure requirements set by the Financial Accounting Standards Board (FASB) under Accounting Standards Codification (ASC) 330. These disclosures help investors assess a company’s inventory valuation and cost flow assumptions.

One key disclosure is the LIFO reserve, which shows the difference between inventory valued under LIFO and what it would be under FIFO or another method. This helps stakeholders understand LIFO’s impact on profits and balance sheet values.

Companies must also disclose how LIFO affects the cost of goods sold (COGS) and net income. Since LIFO typically results in higher COGS during inflation, it lowers taxable income and reported earnings. These effects are often explained in financial statement footnotes.

Auditors review inventory records, verify LIFO reserve calculations, and assess whether financial statements fairly represent inventory costs. If discrepancies arise, companies may need to adjust their reporting. The Securities and Exchange Commission (SEC) monitors LIFO disclosures for publicly traded firms, and misleading or incomplete reporting can result in enforcement actions.

Changing to LIFO from Another Method

Switching to LIFO requires careful planning due to its long-term tax implications and compliance obligations. Under IRS regulations, a company must file Form 970, Application to Use LIFO Inventory Method, with its tax return for the year of the change. This election remains binding unless the IRS grants approval to revert to another method.

One challenge is establishing a beginning inventory layer under LIFO. Unlike other accounting changes that may allow a prospective transition, LIFO often requires recalculating inventory costs based on historical data. If detailed records are lacking, this process can be complex. Many businesses use the dollar-value LIFO method, which groups inventory into broad pools rather than tracking individual items, simplifying administration while maintaining compliance.