July 6, 2016

What Does LIFO Conformity Mean?

What Does LIFO Conformity Mean?

Manufacturers whose inventory is experiencing inflationary prices can reduce taxable income by reporting inventory using the Last In, First Out (LIFO) method. With the LIFO method, the most expensive inventory is purchased most recently, and since that is the inventory assumed to be sold, the remaining inventory in stock has a lower value. This is a great result for tax purposes, but not necessarily for GAAP purposes.

The LIFO conformity rule says that if LIFO is used for tax purposes, it must also be used to compute income for financial statements. Unfortunately, this results in reporting lower GAAP financials results to investors, lenders, shareholders and creditors. FIFO reporting can be used for management or other internal reporting but not for external reporting. Supplying non-LIFO-based financial statements to outside investors or banks would violate LIFO conformity and potentially force the taxpayer to no longer use LIFO for tax purposes. Depending on the amount in LIFO reserve, this could mean a significant increase in taxable income.

Due to increased international presence of midsize manufacturers, International Financial Reporting Standards (IFRS) is now adding complexity to this rule. The goal of IFRS is to have a global common method of maintaining books and records so that the financial statements in each country are comparable and understandable. LIFO is not an accepted way of reporting inventory under these standards. This could cause LIFO conformity issues if a U.S. company is part of a larger consolidated group with various foreign entities in countries that have adopted IFRS.

There have been several situations where the IRS determined that LIFO conformity is not violated as a result of consolidated financial statements issued by the foreign parent using a non-LIFO method because the parent owned operating assets of substantial value that are used in foreign operations. In this case, substantial means 30% of total operating assets of the consolidated group. If the 30% test is not met, facts and circumstances will be used to decide if the foreign parent is engaged in substantial foreign operations.

If there is one key takeaway for CFOs, it’s this: Before issuing anything to the public, make sure all external reporting of earnings does not violate the LIFO conformity rule.