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FIFO and Inventory Valuation for Income Tax

Article written by EricBank

The cost to purchase raw goods and inventory is a major factor affecting the net income of manufacturing and merchandising companies. Typically, inflation causes costs to rise over time, which pressures businesses to increase prices so that they can maintain their profit margins. These higher costs translate into increased deductions for purchased inventory, and this helps to reduce the squeeze on margins. Falling prices, or deflation, is another, albeit rarer, story.

Cost Flow Assumptions

You allocate costs to the goods you sell by making cost flow assumptions. Under IRS rules, you have two alternatives: first in, first out (FIFO) and last in, first out (LIFO). FIFO is like a single-file queue, in which to apply cost to your inventory in the order of purchase. LIFO is like a stack of pancakes: you grab the top one first -- that is, you apply current costs in reverse order to purchase. You have to notify the IRS when you adopt LIFO and when you switch from one method to the other. You also must tell the IRS if you change the way you specify the cost of individual items -- something only sellers of high-priced items such as yachts and cars would do.

Normal Times

If you choose LIFO when prices are rising, you'll be applying the highest costs to inventory purchases first. This is good for you tax bill, because it increases your cost of goods sold (COGS), reducing your balance sheet inventory value, your gross profit and your taxable income. This stems from the equation:

COGS = beginning inventory + inventory purchases - ending inventory

This demonstrates that the higher cost of purchases boosts COGS and cuts inventory value. If you're in the 35 percent bracket, then after taxes, you only shell out 65 cents on each dollar of COGS cost. The bottom line: maximize COGS via FIFO to reduce your tax obligation.

When Times Are Tough

When the economy slows down, prices can fall, which means older costs are greater than new ones. In this situation, FIFO will result in a higher COGS and lower taxes. The IRS frowns on hopscotching between LIFO and FIFO with changing economic conditions. Rather, it wants you to use consistent accounting methods. If you want to alter your cost flow assumption, submit Form 3115 and hope that the IRS approves it.

LIFO Reserve

Unless we are in a deep recession or depression, you're going to prefer LIFO to FIFO. Of course, veterans of the 2007-08 economic storm know how quickly things can turn bad, and during that period, LIFO didn't help business make profits or even keep the doors open. You can quantify the FIFO vs. LIFO tax effects through a metric called "LIFO reserve." This is simply the difference in ending inventory values taken as FIFO minus LIFO. Usually, higher values of ending inventory makes LIFO reserve a positive number. When prices fall, expect a negative LIFO reserve, suggesting that LIFO would give you a higher ending inventory value, lower COGS and a higher tax bill -- assuming you have net income and actually have to pay taxes.