How inventory is accounted for can have a significant impact on your tax bill if your business involves the production, purchase, or sale of products. In some cases — particularly during periods of high inflation and stable inventory levels — adopting the last-in, first-out (LIFO) method could significantly reduce your taxable income and boost your cash flow. But lower taxes are not the only factor you need to consider before switching from the first-in, first-out (FIFO) method.
The Link Between Inventory and Taxes
Inventory itself is not directly taxable until it is sold. Nonetheless, its value bears on your taxes because it affects your net profits. Why? Inventory plays a critical role in the calculation of the cost of goods sold — an expense that can account for 70% of a company’s expenses, according to the Financial Accounting Standards Board’s Investor Advisory Committee.
The cost of goods sold equals beginning inventory plus purchased inventory minus ending inventory. The lower your cost of goods sold expense, the more income your business reports and the more taxes it pays. Conversely, a higher cost of goods sold generally translates to lower taxes.
Two Common Approaches
Inventory is reported on the balance sheet as an asset. The following provides summariers of two popular methods used to assign value to inventory.
1. FIFO. This method assumes that your business sells its inventory in the order that it was purchased. Items that remain in ending inventory are the most recently purchased, which are the highest priced items in an inflationary market. For most companies, this aligns with their actual inventory practices — especially for goods that are perishable or subject to obsolescence.
When prices are rising (that is, most of the time), the FIFO assumption means that the older, and therefore cheaper, items are the first charged to cost of goods sold. This leaves pricier items on the balance sheet. The cost of goods sold tends to be lower under this method than under LIFO, resulting in higher taxable income and greater income tax liability.
2. LIFO. This method assumes you sell your most recently purchased items first. In an inflationary market, inventory on hand will consist of the older, cheaper items, with the newer, more expensive items first charged to cost of goods sold. That methodology increases your business’s cost of goods sold and reduces the business’s income and taxes, compared to the FIFO method.
However, using LIFO can create a problem if inventory levels are declining. As higher inventory costs are used up, companies that use LIFO will need to start dipping into lower-cost layers of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed the company to defer.
In addition, if a C corporation elects S corporation status, the business must include a “LIFO recapture amount” in income for the C corporation’s last tax year. The recapture amount is the excess of the inventory’s value using FIFO over its value using LIFO. Under current tax law, taxpayers can spread out the payments over four years in equal, interest-free installments.
LIFO often is advantageous for federal income tax purposes. However, your choice of inventory accounting method has repercussions beyond tax liability. You may find that nontax issues outweigh the potential tax benefits of changing methods. Reasons to stick with FIFO include:
- FIFO is generally easier to apply than LIFO,
- FIFO typically results in a stronger balance sheet than LIFO in an inflationary market because inventory values under FIFO are based on the most recently purchased items,
- FIFO usually boosts profits on your income statement, and cost of goods sold will generally be stable from one period to another, and
- If FIFO mirrors your production process, it will provide a more accurate picture of your inventory value and overall financial health than LIFO.
In general, companies that use the FIFO method appear financially stronger than they would if they used LIFO. Reporting lower asset values and profits under the LIFO method could prove detrimental if, for example, you’re applying for credit or trying to attract equity investors.
In addition, LIFO is acceptable only under U.S. Generally Accepted Accounting Principles (GAAP). It is not recognized under the International Financial Reporting Standards. You also have to formally elect to use LIFO on your federal tax forms, using IRS Form 970, “Application to Use LIFO Inventory Method.” Once you make the election, you can not resume FIFO without IRS permission.
Finally, LIFO may not provide an accurate reflection of the value of your inventory. When you leave the earliest purchased items in your inventory, some of them could be old or obsolete. They may have no actual value in the current market.
What is Right for Your Business?
As with so many business decisions, there is no one-size-fits-all choice when it comes to choosing the right inventory accounting method. Our accounting and auditing professionals are here to help you determine which method makes sense for your business.
Beyond LIFO and FIFO
Although last-in, first-out (LIFO) and first-in, first-out (FIFO) are the most common inventory accounting methods, others are available. For example, the weighted average cost method is a blend of these two techniques — it combines the cost of new inventory with the cost of existing inventory to produce the weighted average cost. This figure is subsequently adjusted as more inventory is added.
The weighted average cost method is not widely used, though it is accepted under U.S. Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards. When employed, it is generally by companies that sell similarly priced goods.
The specific identification method requires separate tracking of the cost of each inventory item. When an item is sold, its specific cost is charged to cost of goods sold. This process can be cumbersome, so this method is usually reserved for high cost or unique items — such as vehicles, jewelry, and artwork.
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