What's happening with LIFO, the "little giant" of tax deferrals? In light of last year's tax act, is LIFO (a method for valuing inventory on a last-in, firstout basis) fulfilling its potential as small business's greatest opportunity to save on taxes?

A rapidly growing number of smaller companies are adopting it, reports Dan Fensin, partner and director of LIFO services for Blackman, Kallick & Co., a Chicago accounting firm. "As a cure for phantom profits caused by inflation, the lure of LIFO has become almost impossible to ignore or disavow," he says. As testimony to the accelerated interest in LIFO, Fensin cites the experience of his own firm. "Five years ago, only about 10% of our clients who maintained inventories were on LIFO. But as inflation rates mushroomed to double digits, more and more got into it. Now, at least 65% of those clients are on LIFO."

In an interview with INC., Fensin reviewed the benefits of LIFO, itemized changes in LIFO procedures caused by the 1981 Economic Recovery Tax Act (ERTA), and described several recent experiences with LIFO conversion.

Although LIFO first emerged in 1939, when it was written into the tax codes, it was little used and relatively unappreciated until inflation rates began their steady rise. Basically, LIFO removes the latest and highest priced items from inventory, charges them to the cost of goods sold, and leaves the earliest and lowest priced items in inventory. In effect, for tax purposes, the latest items purchased -- at presumably higher prices because of inflation -- are assumed to be the first items sold, thus removing the inflation rate from inventory value. Even at currently lower inflation rates, this results in reduced taxable income, lower taxes, and increased cash flow (see box).

"Even if inflation were to drop to, say, 3%," Fensin points out, "LIFO would still give you the opportunity to shelter 3% of your total inventory value from taxes."

Since 1973, when he handled his first LIFO conversion, Fensin has witnessed continual misunderstanding about the time and effort involved in converting. "Unfortunately, exaggeration and misinformation about problems with LIFO conversion have caused many business owners to put it off. Yet, it's not that difficult to make the switch," he says. "Whatever effort is expended is returned many times, because LIFO is a building process -- the benefits keep accumulating each succeeding year."

As an example, Fensin cites the case of a $14 million plastics distributor that converted to LIFO eight years ago. The company's inventory, for tax purposes, is now running at 50% of its actual value.

"On FIFO [first-in, first-out], at cost, it's a $4 million inventory," notes Fensin. "Using LIFO, it's valued at $2 million." Equally dramatic on a slightly smaller scale, is the experience of a $6 million manufacturer of check protectors. With an inventory of $1.5 million, the company converted to LIFO in 1977 -- a move that has since enabled it to eliminate some $600,000 in "inventory profits."

Fensin has worked with many companies whose inventories and sales are in the area of $50,000 and $500,000, respectively. "Businesses with inventories as low as $25,000 are candidates for LIFO," he emphasizes. "The same techniques apply, regardless of sales volume or inventory size."

Type of business is more important than size, Fensin points out. Conversion to LIFO is easier for manufacturers than for distribution companies, because regulations allow all manufacturers' products to be classified in a single pool for valuing "Putting all items into one pool, called a natural business unit, makes the conversion process less time-consuming, less complicated, and easier to understand," he says.

Once the value of a pool is established for the base year (the beginning of the first year a company elects LIFO), that year becomes "memorialized," because every succeeding year's values are indexed to it. Quantity of items is not the key factor. Instead, the pool's dollar value is extended, using the base-year cost, the end-of-year cost, and the earliest acquisition price.

Most of the time required for LIFO conversion is spent gathering information about the purchase history for the sample items in each pool. Although three methods are available -- using the earliest, latest, or average prices during the year -- most companies opt to use the earliest acquisition price because it is the lowest.

For nonmanufacturers or those engaged in manufacturing plus other businesses, Fensin concedes that working with a number of pools is more complex. But he still characterizes the conversion process as not nearly the oniinous task many business owners and accountants fear it will be.

"Regardless of type of business, it's not necessary to analyze every inventory item individually," he explains. "Streamlining is part of the conversion process. Statistically sound samples and representative product groups can be used to create indexes. They, in turn, can be used to compute the value of inventory -- or LIFO adjustment -- each year compared to the base year."

Because the base year for each company electing LIFO is so strategic, at least as long as inflation exists, Fensin bemoans the loss of benefits because of hesitation. The extension option for filing tax returns up to six months after the due date has allowed many companies to take advantage of LIFO for fiscal years long ended. Fensin is quick to add that shifting to LIFO requires no permission from the Internal Revenue Service. "All you have to do to initiate LIFO is file a Form 970 with your tax return," he says. However, the completion of that form and the filing of financial statements are crucial, he warns. "Many people don't believe that an entire LIFO election can be disallowed just because the forms are filed incorrectly. Uncle Sam doesn't monkey around. Everything has to be filed properly. Every company should look at LIFO as a gift. It helps defer taxes. And those who want to use it must do what's required to take advantage of that gift."

Although LIFO was attractive before ERTA took effect, Fensin emphasizes that it is even more so now, particularly for smaller businesses. Several significant changes have been enacted.

"The government made LIFO easier," Fensin explains. "Companies whose average sales during the last two years were under $2 million may now elect LIFO using a single-pool approach. That's any firm with less than $2 million -- not just manufacturers. Also, the government will publish indexes that companies may use for LIFO rather than having to generate their own. That will eliminate the most time-consuming phase of the conversion."

Another important ERTA revision, he notes, provides more time for adjusting tax payments on inventory carried below cost -- due to obsolescence, for example -- that must be revalued for LIFO Companies electing LIFO for a year beginning after December 31, 1981, now have up to three years to pay amended taxes on that inventory.

The question of obsolete inventory is vital for a company wrestling with the LIFO decision. Because all inventory, regardless of its market value, must be valued at cost for LIFO, obsolete inventory has to be counted. An amended tax return for the previous year, when that inventory was valued below cost, must be filed and additional taxes paid before a company is eligible for LIFO. Fensin admits that if a sizable amount must be paid in amended taxes, the benefits of choosing LIFO initially might be outweighed, but he still recommends it.

"Even if you're down that first year because you've had to revalue obsolete inventory, you're still beginning to build that LIFO reserve," says Fensin. "To delay means that you have to eat inflation's effect for another year."

Besides the question of obsolete inventory, LIFO prospects should always consider several other points:

* How good are your inventory records?

* Do you have adequate control of your inventories?

* Can you create a purchase history from your records?

* What inflation rate have you experienced during the proposed first year of LIFO?.

* Will prices ever return to the level of your proposed base year?

As long as satisfactory record-keeping exists, the company does not expect to liquidate its inventory drastically, and prices continue rising, Fensin asserts, LIFO is "the only way to fly."

As a LIFO proponent, Fensin also strongly recommends that a company electing LIFO keep its banker fully apprised of the conversion and the results it will have on the company's financial statements. "There's no question that the better the LIFO adjustment, the lower the earnings will be. That's the point, of course -- to reduce income and, therefore, taxes. But to the financial community, reduced income due to LIFO has to be clarified so there are no future credit or lending problems. It's important that a company's banker understand that no actual impairment of earnings results because of LIFO," he says.

Last year, Fensin consulted with Early Winters Ltd., a $10 million Seattle retailer and manufacturer of outdoor recreation equipment (see INC., December 1981, page 35). Bill Nicolai, president, had asked Fensin to unravel snags that the company encountered in converting to LIFO. Before Fensin ended his visit, he spent time with the company's banker to explain LIFO's impact.

"Early Winters had an excellent relationship with its banker, who was extremely interested in its conversion to LIFO," recalls Fensin, who estimates that Early Winters will realize a $180,000 inventory reduction in its first year on LIFO. "He was grateful to be included. It paid big 'dividends' and, yet, it was such a simple step to add to the conversion activities."

As long as inflation continues, Fensin tresses, LIFO makes sense. "How can anybody ignore a legal way to reduce taxes?"

LIFO VS. FIFO:

SIZING UP THE SAVINGS

There are two basic methods of valuing inventory, both of which account for the value of items sold, One in first-in, first-out, know as FIFO. FIFO assumes that the beginning inventory (first in) was the first sold (first out). resulting in lower cost of goods sold, higher profits, and higher taxes. This mean that inventory is actually valued on the basis of the cost of the most recent item placed in stock. The other method is last-in, first-out (LIFO). Under LIFO, it is assumed that the most recently purchased (last in) inventory was the first to be sold (first out). Therefore, the cost of goods sold is higher, resulting in lower profits and a smaller tax bite. This means inventory is valued on the basis of the earliest item placed in stock. The table below illustrates the benefits -- i.e., tax savings -- of usng LIFO. The example assumes an inventory of 100,000 units that cost 85 cent each at the beginning of the year and 95 cents each by year-end.

FIFO LIFO

Selling price 100,000 $100,000

Cost of goods 85,000 95,000

sold

Profit on sales $15,000 $5,000

Income tax (46%) 6,900 2,300

Tax savings $ 0 4,600*

* $6,900 (FIFO) minus $2,300 (LIFO)