With inflation near a 40-year high1, companies face urgent inventory accounting challenges. From fuel to food to consumer goods, input costs are rising, and ongoing supply disruptions and geopolitical tensions bring added price volatility. The accounting complexities are especially acute for companies using Last In, First Out (LIFO) inventory method, which already tends to be less predictable than other methods. Now is the time for finance and accounting functions to work with other business units to enhance cost forecasting and mitigation, and even re-assess if LIFO is still right for their company.
Why does LIFO present distinct challenges with high inflation? Under LIFO, the most recently purchased inputs are attributed to Cost of Goods Sold (COGS), while older purchases flow to ending inventory for financial reporting purposes. Amid rising input costs, LIFO tends to result in higher COGS and thus lower net income. Although the LIFO benefits of temporarily reducing taxable income may seem appealing, it could potentially result in less predictable earnings, which may make it more challenging to meet quarterly earnings expectations. Moreover, LIFO requires an extensive historical and detailed record keeping of past unsold inventory. These records are necessary to comply with stringent internal control standards and help support the current value of the inventory, all of which bring added complexity and timing to the financial reporting process.
Now more than ever, Chief Accounting Officers (CAOs) can have a critical role, when addressing inventory accounting challenges. Working alongside supply chain and other business functions, CAOs can be well positioned to identify and drive improvements to LIFO forecasting capabilities. Organizations can consider how utilizing their knowledge of the LIFO inventory method could assist in a variety of activities ranging from developing predictive analytics to enhance supply chain’s ability to forecast short-term movements in material prices.
Some companies using LIFO may benefit from changing inventory methods altogether if the tax cost is not prohibitive. For instance, First In, First Out (FIFO) or average cost can allow for more predictability and better hedging of input costs. However, since inventory methods have major effects on earnings, taxes, and other key financial metrics, any change requires careful planning and execution.
Here’s how a CAO can drive a deliberate process to assess and implement potential inventory method changes.
- Hold discussions with the Chief Financial Officer (CFO), audit committee and/or any other c-suite executives to evaluate benefits and drawbacks of potential changes to inventory methods.
- Partner with tax colleagues to assess the following, given the “book/tax” conformity rule.
- Determine the possible tax cost of shifting from LIFO to an alternative.
- Clarify the process by which a tax accounting method change can occur and the related impacts to the inventory tax basis.
- Inform the external auditor of the potential inventory method change and discuss preferability expectations and criteria.
- Understand any macroeconomic trends when considering the timing of any inventory method change.
Assessing the impacts
- Consider the retrospective application for the adjusted periods and determine both the necessary book and tax LIFO adjustments to be recorded.
- Determine and implement the potential adjustments needed to the financial close process, including any relevant end-to-end procedures and controls.
- Execute new forecasting procedures based on enhanced analytical capabilities or changes to FIFO or average cost.
- Enhance management reporting by better identifying drivers to performance resulting from changes in inflation and material costs.
- Take the opportunity to streamline and expedite the closing process to focus on the analysis of financial data and reporting.
High inflation poses many challenges, but it can also be a catalyst for companies to enhance their inventory accounting. If a change from LIFO to another method is the right approach, CAOs can help lead the way—from overseeing traditional financial reporting requirements to serving as strategic advisors in determining and implementing this business-critical decision.
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- Source: Gabby Jones, “Inflation’s 40-Year High,” NY Times.com, April 13, 2022