LIFO to FIFO Conversion: Accounting and Tax Implications

Companies use various methods to account for inventory costs, with two common ones being Last-In, First-Out (LIFO) and First-In, First-Out (FIFO). LIFO assumes the newest inventory is sold first, while FIFO assumes the oldest is sold first. Businesses using the LIFO method may elect to change to FIFO for financial or strategic reasons. This change, a LIFO to FIFO conversion, is an accounting adjustment with direct consequences for tax liabilities and financial statement presentation, involving specific calculations and regulatory filings.

Rationale for Converting from LIFO to FIFO

A primary reason for converting to FIFO is the impact on reported earnings. In periods of rising costs, the LIFO method matches higher costs against revenue, resulting in lower reported net income. By switching to FIFO, a company expenses its older, lower-cost inventory first, which can decrease the cost of goods sold and increase reported net income and earnings per share, making the company appear more profitable.

The switch also enhances the accuracy of the balance sheet. Under LIFO, ending inventory can be valued at costs that are months or years old, which may not reflect current economic value. FIFO, in contrast, values ending inventory at the most recent costs, providing a figure closer to its current replacement cost. This results in a higher inventory asset value, which can improve financial ratios used in credit analysis.

International comparability is another factor. International Financial Reporting Standards (IFRS), used by most public companies outside the United States, do not permit the use of LIFO. A U.S. company seeking to align its financial reporting with global standards for comparison with international competitors or in anticipation of foreign investment will need to convert to FIFO.

Finally, a company may choose to convert to conform with practices within its industry. If most competitors use FIFO, a company using LIFO may find its financial results are not easily comparable. Adopting the industry-standard method allows for more transparent benchmarking and a clearer assessment of the company’s performance against its peers.

Calculating the Cumulative Effect of the Change

The calculation of the cumulative effect of the change is quantified by the LIFO reserve. The LIFO reserve is the difference between the inventory’s value under LIFO and the value it would have had if the company had been using FIFO. To determine this, a company must recalculate its inventory value under FIFO for all prior periods. This involves determining what the ending inventory value would have been at the end of the preceding year had FIFO been in use.

For example, assume a company’s records show that at the end of the year prior to the change, its ending inventory was valued at $750,000 under the LIFO method. After an analysis of purchasing records, the company determines that if it had been using FIFO, the same ending inventory would be valued at $1,000,000. The LIFO reserve is the difference between these two figures, which amounts to $250,000.

This $250,000 LIFO reserve is the cumulative effect of the accounting change. It represents a pre-tax adjustment that will increase the book value of inventory and retained earnings. This figure is the basis for both the tax adjustments and the financial reporting entries made in the year of the conversion.

Required Tax Filings and Adjustments

Changing from LIFO to FIFO is a change in accounting method that requires permission from the Internal Revenue Service (IRS). To obtain this, a company must file Form 3115, Application for Change in Accounting Method. This form is typically filed with the company’s federal income tax return for the year the change is implemented.

The conversion from LIFO to FIFO almost always increases taxable income by an amount equal to the LIFO reserve. This reserve represents income previously deferred for tax purposes under LIFO. To prevent the substantial tax burden from recognizing this amount in one year, Internal Revenue Code Section 481 provides relief by allowing the taxpayer to spread the income adjustment over a four-year period.

The adjustment is recognized ratably over four tax years, beginning with the year of the change. For instance, if the LIFO reserve is $250,000, the company would increase its taxable income by $62,500 in the year of the change and in each of the following three years. This four-year spread helps smooth the tax impact and allows the company to manage the cash flow consequences of the conversion.

Financial Statement Reporting and Disclosure

Under U.S. Generally Accepted Accounting Principles (U.S. GAAP), a change from LIFO to FIFO is a change in accounting principle that requires retrospective application. This means the company must adjust its financial statements for all prior periods presented as if it had always used the FIFO method to enhance comparability across periods.

The retrospective application is done via a journal entry recorded at the beginning of the earliest period presented, which increases the inventory and retained earnings accounts. For example, using the $250,000 LIFO reserve, the company would debit Inventory for $250,000. The corresponding credit would be to Retained Earnings for $250,000, less any associated deferred tax liability, to reflect the cumulative after-tax effect.

Extensive footnote disclosures are required in the financial statements for the year of the change. The company must state the nature of the change in accounting principle and explain the reasons for it. The disclosures must also describe the effects of the change on the financial statements, including the impact on inventory, net income, and earnings per share for all periods presented.