Understanding LIFO Accounting for the Food and Beverage Industry
On this inaugural episode of Insights À La Carte, an EisnerAmper Food and Beverage Podcast, Rich Colloca, Partner and the firm's National Food and Beverage Practice Leader, and Kevin Nardone, Director in the firm's Private Client Services Group, are joined by Bob Richardson, Vice President of LIFO-PRO. The three cover the basics of last-in, first- out (“LIFO”) accounting and the real-world benefits and tax implications food and beverage businesses leaders need to know about this method.
Rich Colloca:Welcome to EisnerAmper's Food and Beverage podcast series, Insights A la carte. My name is Rich Colloca, of EisnerAmper's Food and Beverage Practice. Today we'll be discussing the LIFO method of inventory. We appreciate our audience taking time to join us today, and for those joining us for the first time, a special welcome.
I'm pleased to be joined today by Bob Richardson of LIFO-PRO, and my colleague Kevin Nardone of EisnerAmper. Bob and Kevin, welcome. And perhaps you can introduce yourself to our audience and tell us a little bit about yourselves.
Bob Richardson:Thanks, Rich. My name's Bob Richardson. I'm a CPA and a vice president of LIFO-PRO. We're a firm specializing exclusively in LIFO outsourcing solutions and software. We partner with companies and CPAs of all sizes, shapes, and forms, and are the leading LIFO experts.
Kevin Nardone:Thanks, Rich, thanks for hosting us today. And Bob, thanks for joining us. My name is Kevin Nardone. I'm a director at EisnerAmper in our private client services group. The majority of my client base is represented by closely held manufacturing and distribution companies, more specifically those in the food and beverage base. And a lot of the clients that I work with have benefited from the application of LIFO. And I think it's great to give an introduction to the concept surrounding this election to those who may not be aware of the benefits.
RC:Just a brief overview of our topic today. Inventory methods are used to value the carrying costs of inventory. These carrying costs are typically recorded on a FIFO, meaning first-in-first-out method, or LIFO, last-in-first-out method, which we'll further discuss. Recent statistics have indicated that approximately 15% of companies in the S&P 500 use the LIFO method of inventory.
With that, Bob, what is the history of LIFO and how does it work?
BR:Well, LIFO came to be in the late 1930s during a time where substantial inflation was occurring, which caused excessive amounts of taxes to be paid on purchase goods that hadn't been sold. And as a result, industry trade organizations and the AICPA lobbied to Congress in support of LIFO. And those efforts led Congress enacting legislation in 1938 to authorize taxpayers to value inventories using LIFO.
And the whole theory behind LIFO is that income may be more accurately determined by matching current costs against current revenues, thereby eliminating from earnings any artificial profits resulting from inflationary increases in inventory costs. So at the heart of the LIFO method is the principle that income is more clearly reflected by matching current costs with current revenues.
RC:What are some of the economic benefits of utilizing the LIFO method?
BR:So LIFO will create material recurring tax deferral or savings. And it's not just a one-time benefit or timing difference between book and tax as you can see with straight line versus accelerated depreciation. An example is when you have rising costs, LIFO is going to create more after tax-free cash flow than any other non-LIFO method. And it also ensures that taxes aren't paid on purchased goods that have yet to have been sold. And it also improves the ability to replenish and maintain an adequate level of inventory.
RC:Can you give us a water cooler, high-level illustration?
BR:Sure. So the LIFO reserve represents a cumulative difference between inventory at cost, so we'll call cost FIFO and LIFO, and it also represents the total taxable income reduction from LIFO. And then the year-over-year change in the LIFO reserve is called LIFO expense or income, where expense represents an increase and income decreases the reserve. So let's assume you have $10 million of inventory at FIFO cost, but eight million at LIFO. So for purposes of this example, you'd end up with a $2 million LIFO reserve.
And to further illustrate, let's assume you have, say 10% inflation for your next year-end LIFO calculation that creates a million dollars of LIFO expense. So to further this example, your LIFO reserve would increase from the $2 million that we started with as of the last period, up to three million for the next period closed.
RC:What type of companies, if you could share some insight, would benefit most from utilizing LIFO?
BR:Well, there are more industries that are good LIFO candidates than those that aren't, but I'll focus on the food and beverage industry, and also touch on some others too. So the food and beverage industry is one of the best LIFO candidates because of the high inflation frequency in inflation levels they've historically had. The food and beverage industry actually represents the biggest share of our client base because of this. In all but a few select subgroups, food and beverages has a long history of consistent and meaningful inflation that can add up to material LIFO tax benefits.
And as a result, there are thousands of companies in the food and beverage space that are on LIFO. LIFO-PROs clients in the food and beverage industry include Kroger, General Mills, Performance Food Group, US Foods, and Dot Foods. And some examples specifically of the best food and beverage companies or industry types that are on LIFO include grocery stores and supermarkets, alcohol and beverage manufacturers, wholesalers and retailers, as well as the food manufacturers and wholesalers.
So it's a great industry for LIFO, and there are a lot of industries that are great candidates. But others outside of the food and beverage space that I'll just quickly touch on are machinery, equipment, furniture, and household durable goods. So these industries are also great LIFO candidates because of many of the same reasons that I just described for food and beverage, high inflation frequency and the level of inflation.
More specifically in these types of industries, these goods are typically in the more advanced stages of demand or production. And these goods are going to end up having more labor and overhead costs and embedded into their prices. So because of this, these types of goods end up having more consistent inflation and end up being shielded from the extreme volatility, deflation, and LIFO recapture that can occur with industries where you have product mixes consisting primarily of raw materials that are in the earlier beginning stages of production.
And lastly, at dealerships. Which most, you're thinking an auto dealer, but it also includes RV, ag and farm equipment, construction, power sports, and any type of transportation equipment dealer, in addition to auto dealers. These are also very good users of LIFO, or more specifically, it's probably one of the industries that are the most predominant users of LIFO. And when the right methods are employed within this industry, LIFO can be implemented and maintained with the lowest amount of administrative burden and outsourcing costs of any of the industries that are great LIFO candidates.
RC:Bob, just one follow up question on your commentary. You mentioned LIFO recapture. Can you elaborate on what LIFO recapture is and how it works?
BR:Well, there's a lot of different terms that you can describe the taxable income that can be created when you're a company that's on LIFO and you have a LIFO reserve change that is negative year-over-year, but LIFO recapture is the most common term. So let's say you have a $2 million LIFO reserve this year ... and we'll call this year 2022. Let's say next year, your LIFO reserve decreases by a million dollars. So that's a million dollars of recapture. And if I'm remembering correctly, if we started off with a $2 million LIFO reserve, we now have a million dollar LIFO reserve.
So when I talk about recapture, the reserve, we're talking about cumulative taxable income reduction from LIFO. So you have varying degrees. If your LIFO reserve is reduced, if you have a $2 million reserve by $10,000, well, you still have $1,990,000 LIFO reserve after that year. So LIFO reserve becomes important, or the recapture within a LIFO reserve becomes important when you're talking about the magnitude. That if you lose 80% of your LIFO reserve as of the last year-end, then that's obviously a material amount.
RC:Bob. Now where do you come into the fold and how do you help companies with LIFO?
BR:So LIFO-PRO has a range of solutions ranging from software to outsourcing solutions. So for outsourcing clients, we essentially try to make being on LIFO as simple as possible. For a company that license our software, that allows companies to minimize the time spent on LIFO in-house, guarantees calculation accuracy, and eliminates audit risk. And our outsourcing clients are provided a LIFO report package, which contains comprehensive documentation including all the information that's needed for audit and review purposes and recording your LIFO journal entries.
And for companies that aren't on LIFO, we provide complimentary benefit analysis. And for companies that are on LIFO, we provide free reviews. So we have a full suite of LIFO solutions, but what we're essentially doing is working alike with CPA firms and companies so they can place their reliance on our reports and count on us to serve as their LIFO subject matter experts, rather than that firm or company to have to develop and maintain in-house expertise to support their LIFO calculation.
And one other point I'd make is, audit and review procedures, we've just been told by clients, greatly simplified when you're either outsourcing to LIFO-PRO or using the software because of the user-friendly documentation.
RC:When you're in discussions with clients from an illustration perspective, do you provide clients with feasibility studies?
BR:Yes. So with the unprecedented inflation, we've performed hundreds of LIFO election benefit analysis over the past couple of years, which you've described as a feasibility study. Those two terms you can consider synonymous. But in any case, the feedback that we've received is very positive because the majority of the companies who obtain a feasibility study or a benefit analysis end up proceeding with electing LIFO and becoming clients.
More specifically, some of the feedback that if you're curious about what is the outcome and what becomes of these feasibility studies, is that a lot are concerned about the risks related to LIFO compliance considerations and timings, but most of those concerns can be overcome with our help. And practically speaking, the benefits of LIFO are so large in a lot of cases that the benefits end up outweighing the costs, and it's just a matter of employing the most optimal efficient methods to apply LIFO. And possibly utilizing something like software or outsourcing makes the benefits far outweigh the costs.
RC:Thanks, Bob, for that comprehensive review. We're going to shift over to Kevin for a couple of minutes. Kevin, you deal with clients all the time. Do you have any thoughts about some of the client concerns that they have when discussing issues such as LIFO?
KN:I have worked through the theory and mechanics of calculations with Bob and my clients over the years. Bob mentioned before about the administrative time associated with the election, and that is always a concern I get from my clients that are considering adopting LIFO.
Bob, you mentioned there isn't a lot of recurring administrative time, but what information is needed to implement the LIFO election?
BR:Sure. So in terms of documentation requirements for companies other than auto dealers considering electing LIFO, all that's needed is this and last year's item detail or perpetual stock status reports. What's also useful to include with those reports, if available, is any applicable product hierarchy, as it can expedite the time spent calculating inflation and minimize the outsourcing costs as well.
Examples include product categories, classes, groups, and lines. For dealerships considering electing LIFO, all that's needed is this and last year's trial balance or balance sheets schedules. And for companies that are already on LIFO, all that's needed to perform a review is your LIFO calculation documentation from the last period closed.
KN:Okay. And as far as the process for the first year and any recurring time, what can you describe that process for us?
BR:So if we provide a free analysis for a company considering electing LIFO, or a company that's already on LIFO so we'll provide a free review, upon being provided the documentation I just outlined, LIFO-PRO performs that analysis or review to quantify the benefits of electing, confirming calculation accuracy, compliance issues, looking at simplification or tax saving strategies if you're a company that's on LIFO. So once we prepare that, we'll deliver it within a week of receiving the required documentation. And we'll try to schedule a discovery call to go over our report findings, recommendations, and calculation and engagement options.
So assuming you've engaged us and the year-end has closed, LIFO-PRO will deliver a report package containing comprehensive calculation documentation. And from a timing perspective, clients are afforded the luxury of sending their documentation to us at their convenience, and we even offer same day turnaround time if needed, to ensure that the deadlines are met. And if applicable, we'll also prepare and deliver the IRS forms required to be filed for LIFO elections and accounting method changes. The good news is ... because that might sound like a lot. On a recurring basis, we manage the bulk of the LIFO load, including performing interim estimates and send out year-end calculation reminders.
So the key takeaway is once you've implemented LIFO on a recurring basis, the only work that's required for our outsourcing clients is to gather information from your accounting system, send it to us, and record your LIFO journal entry after receiving a report package from LIFO-PRO.
KN:Doesn't sound too bad. One of the other follow up questions I always get from clients as well is determining whether or not they can elect LIFO for tax and not financial statement reporting.
BR:Right. So that's a common question we also receive, but the simple answer is no, you can't elect LIFO just for tax and not financial reporting. And this is because of the LIFO conformity rule, which requires for inventories to be reported on a LIFO basis on your financial statements beginning in the year that that it's elected for tax purposes. But with that being said, the conformity rule does allow for an estimated LIFO figure to be used on the financial statement.
So for companies considering electing LIFO approaching their reporting deadlines, LIFO-PRO can quickly turn around an estimated LIFO figure. But the key takeaway to consider is that your expected financial statement issuance date should also be considered your deadline for electing LIFO.
RC:Bob, what is so appealing, especially this year, when making the argument to adopt or convert to LIFO in these inflationary times?
BR:Some of the best LIFO tax deferral savings opportunities seen in the last four to five decades are available this year, since 2022 created inflation that was well or far above historical averages in many industries. So many years worth of LIFO tax benefits can be obtained in a single year by electing in 2022 when compared to a normal inflation period. And one of the best possible times to elect LIFO is in a year with high inflation because it maximizes the likelihood of LIFO creating a tax benefit in perpetuity.
Or said another way, we talked about recapture earlier. So if you started with low inflation in year one, let's say you had a moderate amount of deflation in year two. Well, you're then possibly immediately faced with what we call a debit balance or negative LIFO reserve, which then all of a sudden puts you in a net negative tax position from being on LIFO. So you can avoid that situation from ever occurring by electing LIFO in a high inflation year like we're looking at here in 2022.
RC:There's certainly a lot to unpack here. Based on what you've indicated, is the driving factor just rising prices, or let's say average inventory levels, how do they play into the consideration to utilize LIFO?
BR:So for the most part, rising prices is in fact the most important factor, unless you have substantial inventory liquidations. With that being said, you're asking the question because there's a chance that it could have an impact other than inflation ... factors other than inflation, rather. To give you an extreme example, and I've seen it once in the past several years, is that let's say you start off with half a million dollars in inventory and you had, say 10% inflation. So $50,000 of LIFO reserve in year one.
Well, let's say you grow to $5 million the next year, and then you have a ton of deflation in the next year. So there are considerations where you have extreme examples of inventory materially increasing or decreasing in any given year. But under normal circumstances, which is what we see, 90, 95 plus percent of the time, you're worrying about inflation. So if you have good inflation and you're not expecting for extreme deflation to occur in the future, that's the primary focus. And you don't have to worry so much about, well, inflation is one thing, but I also have to constantly worry about inventory going up or down. Because your LIFO reserve can increase even when inventory balances decrease.
RC:Regarding inventory, is there an optimal inventory dollar level in order for LIFO to be beneficial that clients should be looking at?
BR:Well, there's not an easy answer to this question because it's dependent on the makeup of the product mix and the LIFO submethods being used. For example, a company of any size with a narrow product mix using the IPIC method would benefit from LIFO because there's likely a minimal administrative burden, and or outsourcing costs and sufficient tax benefit to offset those costs. But on the other hand, if you have a diverse product mix and use complex LIFO submethods, the administrative burdens and or outsourcing costs become higher. So a minimum inventory balance is likely necessary to ensure the benefits outweigh the cost.
So with that being said, almost all of our clients have at least a million dollars of inventory, and the majority of our clients have $2 million of inventory. So I suppose a good gauge that you could take away from that question is yeah, look for maybe a million to $2 million of inventory if you're considering a LIFO election.
RC:Let's head over to some client perspectives. Kevin, what has been your client experiences in dealing with LIFO? And can you share some insight as to the challenges that a client may encounter as it relates to the impact on their financial statements?
BR:Absolutely. So for clients of mine that have implemented LIFO, they've really been able to see the benefits of the election. For them, sometimes the hardest part is making the decision and committing to the conversion. It can be a mental adjustment, seeing the impact that the election can have on operating results, seeing the increased costs going through the P&L, and looking at what appears to be decreasing margins. But the important thing is to remember that your lower cost of goods are the ones that are now retained on the balance sheet.
For companies or clients of mine that have bank financing or credit agreements, it's also important to discuss this election and this decision with your lenders and determine what the impact may be on any debt covenants that might be included within the agreements. Many of my clients that utilize LIFO to measure inventory have add-backs for the non-cash adjustment to inventory when calculating debt covenants. In addition to that, whenever you're comparing operating results year-over-year, it's important to break out the charge upon adoption for comparative purposes.
RC:Question for both of you. What is the most common misconception you hear when speaking with clients regarding adopting LIFO?
BR:Well, number one is the idea that LIFO complicates normal management operations and sales functions because costs and the physical flow of goods have to be tracked on a LIFO basis. This is not true. Under dollar value LIFO, most of the undesirable characteristics are avoided because no changes in the way your accounting system tracks costs are made. Said another way, the only change when using dollar value LIFO is to record a top side entry to debit costs of goods sold ... some use what's called a LIFO expense account. And to credit your LIFO Reserve Contra inventory account.
So this means that item costs continue and remain being tracked the same way they did prior to electing LIFO. And so unit costs are never tracked on a LIFO basis. I recall my college accounting course teaching unit or specific goods LIFO, when you look at unit LIFO, you see goods coming in at this dollar amount and going out at that dollar amount. And having to actually look at them as being valued, sold and purchased on a LIFO, not a FIFO basis item by item. So if you have many SKUs, UPCs, et cetera, that would seem like an accounting nightmare to use LIFO. But under dollar value LIFO, you get this tax benefit while avoiding actually tracking the physical flow of goods under a LIFO basis.
Another common misconception is that material reserve recapture can occur when normal inventory liquidations or deflation occurs. This is also not true. The primary driver, as we discussed earlier, of determining the change in your reserve is determined by inflation. And material or complete LIFO recapture does not occur from normal inventory liquidations or small amounts of deflation. So if you had a little bit of deflation, you will have some LIFO recapture. But to further my point from earlier, it'll be a small amount. And there are examples where you can actually grow your LIFO reserve even when balances inventory has decreased year-over-year.
Which leads into my next misconception, is that your reserve can't grow unless inventory balances also grow. And it's not true because if you have inflation, your reserve will increase unless you have a material inventory liquidation.
RC:I'm sure there's a lot to navigate through with clients. Kevin, what are some of your thoughts?
KN:For me, some people do shy away from the concept of changing things up, or saying let's just keep doing it the way we've always done it. And the truth is, if you have a conversation about options available and you have the right help, like engaging someone like Bob with experience in this arena, it's a much smaller hill to climb and you have help in getting there. So it is an obstacle that can be overcome, you just have to get over that hill.
RC:I realize nobody has a crystal ball, and as Yogi Berra said, "It's tough to make predictions, especially about the future." Do you think that we will see inflation cycles occur the same way as they have over the last 25 years, or do you think they'll occur in much different patterns in the future?
BR:In the absence of a crystal ball, I have no reason to believe that future inflation cycles will materially change from the way they've occurred in the past. And knowing this, I don't expect to see the inflation we've seen over the past two years for many decades, and I'd also expect to see inflation normalize within the next year or two. But what's encouraging to me from a LIFO advocacy perspective, at least for the near term, is the current and anticipated short term labor environment. And when you consider the tightness of the labor market and the fact that many firms are now price takers rather than makers when it comes to paying their workers, I believe the labor costs will keep inflation around or slightly above the Fed's 2% mandate here in the short term.
And from a LIFO advocacy perspective, it's encouraging to me because prior to COVID, there was probably a decade long period where inflation was what some would describe as minimal, but from a factual perspective, often below the Fed's 2% mandate. Taking this all into account, we're already seeing demand subsiding. Also, raw material costs continuing to decrease as they have recently. The fact that the tight labor market is continuing supports this argument that inflation will probably remain closer to or above the 2% range that the Fed likes to mandate in the foreseeable future. And so for tax deferral tools like LIFO, it appears that they'll remain very valuable and relevant.
RC:Bob, you touched on labor. How does labor fit into the equation here?
BR:Well, for most companies, labor is going to be included in the inflation calculation. And depending on the methods that you use, some form or fashion of labor is going to get cooked into the LIFO cake. But I guess just from a practical perspective, if labor costs had remained steady over a period of time, but let's say we've now approached COVID, and the labor market's tight and wages have now had to have been increased to attract your new labor force ... so let's say you had a five, 10, 20% increase in labor costs. Well, those labor costs are going to be reflected in the inflation that you're calculating from a LIFO perspective.
So you obviously have many other components. We're talking raw materials as well as overhead costs, as well as other items that could be reflected in your inflation calculation. But it's important to understand that in varying degrees, labor will represent some percentage of your inflation calculation. And depending on what type of firm you are, it could represent a material portion of your inventory costs.
RC:As we wrap up here today, Kevin, Bob, what are your biggest takeaways that companies should consider regarding inventory?
KN:For me, it's really the curiosity that people have had on LIFO in the past. I mean, every year I speak to my clients and they say costs are going up. We never really talk about prices coming down. We may mention that they're stabilizing, but not going down. If you've ever really considered adopting LIFO in the past or have thought about getting a feasibility study done to see what it might look like, this is certainly the year to look into it and explore your options.
BR:LIFO has been a GAP and IRS approved accounting method for over 80 years. It's here to stay, and there are no current or near term threats to LIFO. And LIFO is being used now more than ever by tens of thousands of companies of all sizes, shapes, and forms. Most of our clients have been on LIFO for many decades because it has essentially acted as a tax deferral annuity that grows larger and larger over time. And in many cases, the LIFO tax benefits far outweigh the costs and can be extremely simple when you partner with a firm like LIFO-PRO.
RC:Bob, Kevin, it's been a pleasure, and thank both of you for sharing your insights today with our audience. I'd also like to thank our audience for attending today's episode of Insights A la carte, an EisnerAmper podcast series. We hope you'll join us again on our next podcast. And please feel free to visit us at eisneramper.com for more information on these topics and a host of other topics.
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