Recent supply shortages may cause unexpected problems for some businesses that use the last-in, first-out (LIFO) method for their inventory. Here’s an overview of what’s happening so you won’t be blindsided by the effects of so-called “LIFO liquidation.”

Inventory reporting methods

Retailers generally record inventory when it’s received and title transfers to the company. Then, it moves to cost of goods sold when the product ships and title transfers to the customer. You have choices when it comes to reporting inventory costs. Three popular methods are:

1. Specific identification. When a company’s inventory is one of a kind, such as artwork or custom jewelry, it may be appropriate to use the specific-identification method. Here, each item is reported at historic cost and that amount is generally carried on the books until the specific item is sold.

2. First-in, first-out (FIFO). Under this method, the first units entered into inventory are the first ones presumed sold. This method assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices.

3. LIFO. Under this method, the last units entered are the first presumed sold. Using LIFO usually causes the low-cost items to remain in inventory. Higher cost of sales generates lower pretax earnings as long as inventory keeps growing.

Downside of LIFO method

LIFO works as a tax deferral strategy, as long as costs and inventory levels are rising. But there’s a potential downside to using LIFO: The tax benefits may unexpectedly reverse if a company that’s using LIFO reduces its ending inventory to a level below the beginning inventory balance. As higher inventory costs are used up, the company will need to start dipping into lower-cost layers of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed the company to defer. This is commonly known as LIFO liquidation.

Retailers, such as auto dealers, that have less inventory on hand in 2022 may be facing this situation. Higher tax obligations could exacerbate any financial distress they’re currently experiencing.

Fortunately, the House is currently considering legislation — the Supply Chain Disruptions Relief Act — that would provide relief to auto dealers affected by LIFO liquidation. Specifically, the bill would let them wait until the end of 2025 to replace their new vehicle inventory for purposes of determining income for sales in 2020 and 2021. Stay tuned for any progress on this proposed law.

© 2022

 

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