The Pros and Cons of Using LIFO Accounting
When asked whether they’d like to lower their income taxes, most dealership owners would answer, “Sure, sign me up!” One of the most effective ways for dealerships to accomplish this is by adopting LIFO accounting.
As you’re probably aware, LIFO stands for “last in, first out” because, when calculating the cost of goods sold, it counts the last vehicles that arrived on the car lot as the first vehicles sold. Conversely, FIFO accounting – or “first in, first out” – counts the first vehicles that arrived on the lot as the first vehicles sold.
Which choice is better depends on various factors. But if you’ve dismissed the idea of using LIFO accounting in the past, it doesn’t hurt to reconsider the benefits of this approach.
Using LIFO can reduce current income taxes for your dealership if the price of vehicles is rising, as it usually is. This is because counting the vehicles that arrived most recently as the first ones off the lot raises the cost of goods sold, which lowers net income and current taxes.
An example helps illustrate the concept. Let’s assume that a dealership paid $20,000 for a 2016 model car in the spring and $22,000 for the same model vehicle in the fall. In December, it then sold one of these cars for $26,000.
From an income tax standpoint, the dealership can count either of these vehicles as having been sold. If it counts the car it bought in the fall with the LIFO method, the taxable profit on the sale would be $4,000. However, if it counts the car it bought in the spring with the FIFO method, the taxable profit on the sale would be $6,000.
In addition to lowering current taxes, using LIFO can result in other benefits for your dealership. These include:
- Making it easier to match your inventory costs to revenue,
- Minimizing write-downs of vehicles to fair market value because of declines in inventory costs, and
- Improved cash flow.
Also, the tax benefits of LIFO accumulate from year to year. This results in a LIFO reserve, which is the difference between LIFO and FIFO inventory calculations. The LIFO reserve is kind of like an interest-free loan from the IRS, and it can grow very large over a number of years.
Note: You can also use LIFO accounting in your parts department. This may increase the cost of goods sold for parts and accessories, thus lowering profits and income taxes.
The fine print
On the surface, using LIFO accounting would appear to be an easy call for dealerships. However, there are a few details in the “fine print” of LIFO accounting rules you need to understand before deciding which accounting method you should use.
The tax benefits of using LIFO rest on the fact that LIFO reduces your dealership’s profit on each vehicle sold. While this is good from a tax standpoint, it’s bad from a financial statement reporting standpoint. And if you use LIFO for figuring your income taxes, you also have to use it on your financial statements – which will lower your reported net income. Therefore, publicly traded dealerships often use FIFO because they usually want to report higher, not lower, profits to their shareholders.
Meanwhile, if you own a privately held dealership and are planning to put it up for sale soon, think carefully about using LIFO. For one thing, to maximize your sales price, you’ll want to show higher profits – not necessarily a lower tax liability. Also, you’ll have to recapture the LIFO reserve into income when you sell if the transaction is structured as an asset sale. Doing so will reduce your after-tax proceeds from the sale.
In addition, when using LIFO, you must record the LIFO reserve in your inventory records while also performing annual LIFO valuations. The extra effort and cost incurred to complete these accounting and recordkeeping tasks may dissuade some dealerships from opting for LIFO over FIFO accounting.
Your best decision
Under the right circumstances, using LIFO accounting can be a smart tax-saving move for dealerships. But there isn’t a one-size-fits-all approach for deciding which inventory accounting method you should use. So, be sure to talk to your accounting professional for assistance in making the best decision for your dealership.
Dealer Insights - November/December 2016