How to Choose the Optimal Inventory Accounting Method for Your Manufacturing Business
Posted by Jonathan Roller on August 13, 2024
Selecting the right accounting method for valuing your manufacturing company’s inventory can have a substantial impact on your tax obligations. Below, we address key considerations regarding the tax and financial implications of the two most common inventory accounting methods: First-In, First-Out (FIFO) and Last-In, First-Out (LIFO).
How Does Inventory Accounting Impact Taxes?
The value of your inventory is a crucial component in calculating the Cost of Goods Sold (COGS), which directly influences your taxable income. Generally, COGS is calculated by adding the beginning inventory and purchased inventory, then subtracting the ending inventory. When COGS decreases, your taxable income increases, leading to a higher tax bill. Conversely, an increase in COGS results in lower taxable income and reduced tax liability. It's important to note that the “LIFO conformity rule” requires companies to use the same inventory accounting method for both tax reporting and financial statement purposes.
Differences Between FIFO and LIFO
The FIFO method assumes that your company sells inventory in the order it was produced. This means that the items remaining in inventory at the end of the reporting period are the most recently manufactured, and their value is based on the latest costs. FIFO is particularly relevant for manufacturers dealing with perishable goods or products that become obsolete over time, as it aligns with the actual flow of inventory.
Since costs typically increase over time, FIFO generally results in older, less expensive inventory being charged to COGS, leaving more recent, higher-cost items on the balance sheet. As a result, COGS is lower, profits are higher, and so is the income tax liability under FIFO.
On the other hand, the LIFO method assumes that the most recently produced items are sold first. This method is often used when the manufactured products have a longer shelf life, such as clothing or heavy machinery. Under LIFO, in periods of rising prices, the higher-cost, newer inventory is charged to COGS first, leading to a higher COGS and lower profits, which in turn reduces income taxes.
Important Note: LIFO is only permitted under U.S. Generally Accepted Accounting Principles (GAAP) and is not allowed under International Financial Reporting Standards (IFRS). If your business is subject to IFRS reporting requirements, using LIFO for GAAP purposes could complicate IFRS reporting.
Additional Considerations
When choosing or changing your inventory accounting method, it's essential to consider factors beyond just tax implications. While FIFO is generally easier to implement and tends to provide a stronger balance sheet, with higher inventory asset values and reported profits, it may not always reflect the most accurate financial health. Higher profits might be advantageous when reporting financials to investors or lenders, but they could also present a rosier picture of cash flow and profitability than what actually exists.
LIFO, while potentially reducing taxes during inflationary periods by lowering reported profits, may not always be beneficial. Lower profits can negatively impact your ability to attract investors or secure credit. Additionally, the IRS requires a formal election to use the LIFO method via IRS Form 970, and once chosen, switching back to FIFO requires IRS approval. Moreover, LIFO may result in less accurate inventory valuation, as older items may no longer be marketable due to age or obsolescence.
Also, be aware that LIFO can create challenges if inventory levels decline. As the older, lower-cost inventory layers are used, this can lead to taxes on “phantom income” that was previously deferred under LIFO.
Furthermore, if your business transitions from a C corporation to an S corporation, the company must include a “LIFO recapture amount” in its income for the final C corporation tax year. This recapture amount is the difference between the inventory's value under FIFO and its value under LIFO, and it can be paid over four years in equal, interest-free installments under current tax law.
For manufacturers of unique items or products with long production times, neither FIFO nor LIFO may be suitable. In such cases, alternative methods like specific identification or percentage of completion may be more appropriate.
Selecting the Right Method for Your Business
Choosing the appropriate inventory accounting method is a critical decision with far-reaching consequences for your manufacturing company’s taxes, net income, balance sheet, and overall financial health. We can assist you in determining the most suitable method based on your specific circumstances.
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Jon leads audits, reviews, compilations, tax, and consulting services for manufacturers, contractors, and other commercial business entities. He serves as the audit practice leader for the Firm's manufacturing and construction niches and manages the Firm’s pre-qualification to perform third-party reviews of tax credit applications for the Film Industry according to agreed-upon procedures established and published by Empire State Development (ESD). In addition, Jon serves a variety of exempt organizations.