Market and economic conditions are always in flux, perhaps now more than ever. Businesses are struggling to maintain profitable margins, thanks to a spike in global prices for a variety of goods that stems from the current supply chain disruption, recent financial policy decisions, and ongoing world events. Fortunately, every challenge comes with an opportunity. In this case, near-term tax savings are a possibility when considering options for inventory accounting.
Last in, first out (LIFO) is a method of inventory accounting that records the presumably higher cost of recently produced or purchased items as the first to be expensed as cost of goods sold (COGS). At the same time, older, presumably less-expensive items are reported as inventory. In the current inflationary environment, when the cost to produce or purchase goods rises, using the LIFO method rather than the first in, first out (FIFO) method typically lowers taxable income and results in a lower tax liability in the environment of rising prices.
Is LIFO right for your business?
Businesses that elect to use LIFO typically carry relatively large inventories, such as retailers, manufacturing companies, and auto dealerships. Under the LIFO conformity rule, which the IRS strictly enforces, once a company elects LIFO for tax purposes, it must report any financial statements that are submitted to third parties under the LIFO method of accounting as well. Once a company elects LIFO for tax purposes, it must remain on the LIFO method of accounting for a minimum of five years.
Many businesses use the LIFO method for extended periods of time to enhance cashflow and demonstrate financial strength. However, if your business elects to stop using the LIFO method after five years, the deferred income must be recognized over a four-year spread and could substantially increase tax liability at that time.
What are the alternatives?
If LIFO isn’t for your business, you may want to consider using “lower of cost or market” to lower inventory carrying costs, which would in turn increase COGS. A business should look at its subnormal goods to value inventory below actual cost if specific items are demonstrated to be unsalable at current market prices due to customization, damage, surplus, changing styles, or if they are obsolete. (A market downturn and lower demand in and of themselves are not justification for subnormal goods accounting.) The write-down of the value of inventory from cost to current market value lowers the value of inventory on the balance sheet and increases COGS on the income statement, resulting in lower taxable income and tax liabilities.
Talk with your Rehmann advisor for guidance on potential tax law changes and best practice accounting principles and methodologies that can help your business navigate uncertainty and drive your success now and in the future.