Taking stock of your inventory accounting method

If your business involves the production, purchase or sale of merchandise, inventory accounting can have a significant effect on your tax bill. In some cases, switching inventory accounting methods from first-in, first-out (FIFO) to last-in, first-out (LIFO) can reduce your taxable income, giving your cash flow a boost. But tax savings aren’t the only factor to consider. You should also evaluate the effect the change will have on your financial statements.

LIFO vs. FIFO

A common inventory accounting method for financial statement purposes is the FIFO method. FIFO assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices. The LIFO method operates under the opposite assumption: It allocates the most recent costs to the cost of sales.

If your inventory costs generally rise over time, LIFO offers a definite tax advantage. By allocating the most recent — and, therefore, higher — costs first, it maximizes your cost of goods sold, which minimizes your taxable income. Keep in mind that LIFO involves more sophisticated record keeping and more complex calculations, so it’s more time-consuming and expensive to use than FIFO.

Making the switch

If you’re contemplating a switch to LIFO, beware of the IRS’s “LIFO conformity rule.” It generally requires you to use the same inventory accounting method for tax and financial statement purposes. Switching to LIFO may reduce your tax bill, but it will also depress your earnings and reduce the value of inventories on your balance sheet, which may place you at a disadvantage in comparison to competitors that don’t use LIFO. There are various issues to address and forms to complete, so be fully informed and consult your tax advisor before making a switch.

LIFO can create a problem if your inventory levels are declining. As higher inventory costs are used up, you’ll need to start dipping into lower-cost “layers” of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed you to defer. If you use LIFO and this phantom income becomes significant, consider switching to FIFO. It will allow you to spread out the tax on phantom income over a four-year period while giving your balance sheet a boost.

One last caveat about using LIFO: If your business is structured as a C corporation and you change your structure to an S corporation, you’ll have to include a “LIFO recapture amount” in income for the C corporation’s last tax year. The recapture amount is the excess of your inventory’s value using FIFO over its value using LIFO. You can spread out the tax payments over four years, however, in equal, interest-free installments.

Simplifying LIFO

One of the biggest challenges in using LIFO is the need to measure changes in inventory costs. If you currently use LIFO, you may be able to enjoy additional savings by electing to use the inventory price index computation (IPIC) method. It may enable you to reduce administrative costs — and it might even generate greater tax benefits — if you rely on government indexes to calculate LIFO values rather than developing an internal index.

In addition to simplifying LIFO computations, IPIC may increase your tax savings because government indexes often reflect greater inflation than internal data will. Also, you may be able to complete your calculations sooner by using an index published before your year end.

A big impact

The method you use to account for inventory can have a big impact on your tax bill and financial statements. It’s a good idea to review the method periodically to ensure that it provides the best fit with your current financial situation. •