For businesses that maintain inventory, the method used to account for that inventory can have important financial and tax consequences. Inventory accounting affects cost of goods sold, reported profits, taxable income and, ultimately, the amount of income tax a business may owe. This makes the choice of inventory accounting method an important consideration, particularly during periods when the costs of goods, materials and other inputs are changing. Two of the most widely used inventory accounting approaches are first-in, first-out (FIFO) and last-in, first-out (LIFO).
Your inventory's value is part of the formula for determining the cost of goods sold (COGS). COGS, in turn, affects your taxable income.
COGS generally is the sum of the beginning inventory and purchased inventory, less the ending inventory. As your COGS expense drops, your reportable income increases, along with your tax bill. On the flip side, your tax liability falls as your COGS expense climbs. The "LIFO conformity rule" generally requires businesses to use the same inventory accounting method for tax and financial statement purposes.
The FIFO method assumes that a business sells its inventory in the same order that it was acquired. That means the items in your inventory at the end of a reporting period are the most recently made, so the inventory's value is computed based on the most recent cost. This method reflects the real-world physical inventory movement for most businesses, particularly those that purchase perishable products or goods that become obsolete after a certain period.
Because costs tend to rise over time, the FIFO method generally results in the older and less expensive inventory items being charged to COGS; the more recent and costlier items remain on the balance sheet. Under FIFO, COGS is lower and profits are greater, as is the income tax liability.
Conversely, the LIFO approach assumes businesses sell their most recently acquired items first. It's therefore most often employed when the items have a longer "shelf life," such as clothing and heavy machinery. But most organizations don't leave older items sitting in stock.
When prices are on the rise, your inventory under LIFO will comprise older and cheaper products, and the newer and more costly items will be charged to COGS first. With a higher COGS, profits and income taxes are generally lower under LIFO.
Important: The LIFO method is available only under U.S. Generally Accepted Accounting Principles (GAAP) — it's not permitted under International Financial Reporting Standards (IFRS). If you're subject to IFRS reporting requirements, opting for the LIFO approach for GAAP purposes will complicate your IFRS reporting.
Manufacturers should look beyond just the tax implications when selecting or changing their inventory accounting method. Additional factors could end up outweighing the tax benefits.
For example, FIFO is generally easier to apply than LIFO, and it typically will give you a stronger balance sheet because the inventory asset will be higher. The profits reported on your income statement generally also will be higher. These upsides could be beneficial when reporting financial results to investors or lenders. Assuming FIFO reflects your actual processes, your inventory value will be more accurate. On the other hand, your cash flow and profitability may appear healthier than they are in reality.
As for LIFO, it usually reduces taxes in inflationary periods because it reduces profits, but this isn't always a good thing. Lower profits can work against you when you're seeking investors or applying for credit.
Your inventory accounting method can influence much more than how inventory appears on your financial statements. It can affect taxable income, profitability, balance sheet values and key financial ratios — potentially influencing lending decisions, creditworthiness and your ability to attract capital. Because the best approach depends on your business's cost trends, financial objectives and tax situation, it's important to weigh the options carefully.
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