The method for valuing inventory is a big decision for any manufacturer or wholesaler/distributor. The system you choose can have large effects on your financials and your taxes.
To determine which method of inventory makes most sense for you, you must first understand the difference between the two types of valuing inventory, the first in first out (FIFO) method and the last in first out (LIFO) method. The FIFO method of accounting assumes that inventory purchased first is sold first and newer inventory remains unsold. Thus, cost of older inventory is assigned to cost of goods sold and newer inventory is assigned to ending inventory. The LIFO method, on the other hand, assumes the most recently purchased items are sold first. Under this method, ending inventory always reflects the costs for older inventory items while the more recent purchases are included in the cost of goods sold.
Now that we have a handle on the difference between the two methods, now the question is am I permitted to use either method for tax purposes? Everyone can automatically use the FIFO method. However, you must meet certain standards and file for a change of accounting with the IRS to use LIFO for tax purposes.
To use the LIFO method for tax purposes:
- A company must use the LIFO method for book purposes as well maintain sufficient records to support their LIFO calculations.
- A company must file for a change in accounting method with the IRS in order to use the LIFO method.
The LIFO election is irrevocable and once adopted, must be utilized in all subsequent years unless the IRS approves a change to another method. If the taxpayer does terminate LIFO, the taxpayer may not re-elect the LIFO method for at least 5 years.
In addition to determining if you can use it for tax purposes, you must also look at several different aspects of your company’s business. One of the main items that should be looked at is the inflationary trend of inventory. If a company’s inventory prices are constantly rising, then the use of LIFO can be very beneficial. Another large consideration in the decision to switch to LIFO is the administrative burden that comes with the inventory method. Accounting for inventories under the LIFO method is comparatively complex to the FIFO method. Generally, the fewer the pools, the lower the likelihood of a liquidation and the lower the resulting taxable income. Fewer pools also minimize the administrative burden associated with accounting for LIFO inventories.
In addition to the administrative burden, companies need to be conscious of the changes that the inventory method will make to their financial statements. LIFO will affect the income statement, balance sheet and cash flow statements, which will in turn have an effect on the ratios used to measure and compare the company’s profitability, liquidity, activity and solvency. This could in turn affect the company’s ability to borrow from banks as well as attracting investors.
If you think the switch to LIFO could be beneficial to your company or want more information, please contact a member of the Barnes Dennig team by calling 513.241.8313 or by filling out this contact form.