07 Nov Method lessons learned
You have choices when it comes to reporting inventory costs. One popular technique — the last-in, first-out method — assumes that merchandise is sold in the reverse order it was acquired or produced. That is, it allocates the most recent costs to the cost of sales. Although this method is often preferred for tax purposes, internal accounting personnel may be hesitant to use it for various reasons. So why would you use this method?
Assuming your inventory costs generally increase over time, LIFO offers a definite tax advantage over other inventory reporting methods. By allocating the most recent — and, therefore, higher — costs first, It maximizes your cost of goods sold, which minimizes your taxable income.
Sounds good but why else would you use this method? In contrast, the first-in, first-out (FIFO) method 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. This will make your Indianapolis CPA happy too!
Financial reporting challenges
Before you jump headfirst into using this, it’s important to recognize that it’s not permitted under International Financial Reporting Standards. The approach also involves sophisticated record keeping and calculations. That means there are a few things to consider regarding the question “why would you use it?”
For example, the “LIFO conformity rule” generally requires you to use the same inventory accounting method for tax and financial statement purposes. Switching to it may reduce your tax bill, but it could also depress your current earnings and reduce the value of inventories on your balance sheet, thus giving the appearance of a weaker financial position.
This also 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 method previously has allowed you to defer.
Moreover, if a C corporation elects S corporation status, the business must include a “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 this method. Fortunately, you can spread out the tax payments over four years in equal, interest-free installments.
One of the biggest challenges in using it is the need to measure changes in inventory costs. If you currently use this method, you may be able to enjoy additional savings by electing to use the inventory price index computation 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.
Right for you?
If you’re asking “why would you use this method” or contemplating a switch to it, there are various issues to address and forms to complete. Contact us to help decide whether it’s right for your business. As an Indianapolis CPA firm, we look to provide quality advice and service. Look us up in Indianapolis on your mobile device under “CPA near me” or message us at [email protected]