With inflation at record highs, switching inventory valuation methods from first-in, first-out (FIFO) to last‐in, first‐out (LIFO) could help mitigate the effects of inflation by reducing your tax burden and increasing cash flows available for reinvestment. FIFO assumes that the first units produced or purchased (in inventory) are the first to be sold, and the costs of these units sold are allocated on that same basis. The opposite approach is used for valuing the remaining inventory. Units still in inventory are valued at the most recent costs of production or acquisition. LIFO assumes that the last units produced or purchased (in inventory) are the first units to be sold and costs are assigned accordingly. This means that if a company has a large amount of inventory showing high levels of inflation, selling the most recent inventory first will allow you to allocate the inflated costs of sales to produce or purchase to these items, therefore reducing taxable earnings on those sales. Alternatively, under FIFO you would be allocating lower historical inventory costs to those same items being sold at inflated prices, therefore increasing taxable earnings.
When a taxpayer elects a change in accounting method, treasury regulations require Form 3115, Application for Change in Accounting Method, to be filed. This form includes questions that address the type of change and underlying requirements. An analysis of the changes to taxable income is also required to be included, and the net taxable income effect (called an IRC Sec. 481(a) adjustment) is reported as either a positive or negative income adjustment. The IRS generally provides favorable terms for a taxpayer-initiated accounting method change, including a one-year spread of a negative (favorable), and a four-year spread of a positive (unfavorable), Sec. 481(a) adjustment. However, once a taxpayer files a change in accounting method, they are not permitted to request another change (for that same item), essentially locking you into that new election, for five years.
This strategy of switching to LIFO would not be advantageous for everyone, especially companies that have concerns about current earnings or profit margins. Industries that would see the most benefit from this switch include manufacturers, distributors, and retailers (due to their high levels of non-perishable inventory). The ideal candidate for switching would also need to have a large amount of prior year inventory, the higher the better, to make the switch worth it. As the inventory value differential between LIFO and FIFO grows so do the potential tax savings from switching, therefore making this a more attractive strategy. A quick calculation to determine the valuation difference between the two inventory methods will help you determine if the switch makes sense for you. Please consult your tax professional, as there could be other factors to consider before deciding to switch methods.