Accounting for inventory is one of those pesky tasks that keeps business owners up at night. They must think about how to value their inventory, how to assign prices to specific units and how to write inventory down when it becomes worthless. The new administration seemed to acknowledge these frustrations, because the recent tax reform package – the Tax Cuts and Jobs Act – provided a route for relief. Today, corporations with average gross receipts of less than $25 million can use the cash method of accounting – up from $10 million. This means that many businesses will be able to immediately expense their inventory rather than accounting for it at all. However, we recognize this solution won’t work for everybody; companies with average gross receipts exceeding $25 million and companies who would rather stretch their expenses over many years will still need to learn all of the nitty gritty rules for properly accounting for their inventory. We discussed some of the more confusing issues about valuing inventory in our article titled When Is My Inventory Worthless or Worth Less?, and today we’d like to discuss another aspect of inventory accounting: cost flow assumptions.
Cost Flow Assumptions: Necessary for Inventory Valuation
Cost flow assumptions, like FIFO, LIFO and weighted average, are methods that businesses use to assign a specific cost to any one item of inventory as it is sold. FIFO, which stands for First In, First Out, operates under the assumption that the first item you purchase will be the first item that you sell. In other words, you sell your oldest items first. LIFO, which stands for Last In, First Out, is just the opposite; it assumes that you will sell your newer items first. Weighted average is the happy medium between the two, where you take the average of all unit costs to determine value.
All three methods have their advantages and disadvantages, and using one over the other may greatly impact your financials and your tax bill.
Which Should You Choose?
LIFO is often the ideal choice for companies hoping for a tax break. Think about it: since inventory costs typically rise over time, it stands to reason that the most recent inventory items purchased will cost the most money. If a company uses the LIFO method, it will be able to assign the highest costs to the items that it sells, resulting in the smallest profit for tax purposes.
For book purposes, companies have the opposite goal; they want to show investors that they are highly profitable. Business owners prefer the FIFO method for book purposes because the older items cost less, so when they are sold, their Cost of Goods Sold will be low and their profit will be high.
Unfortunately, taxpayers are not permitted to simultaneously use LIFO for tax purposes and FIFO for book purposes. In order to recognize the tax breaks provided by LIFO, companies must do two things: (1) begin using LIFO for book purposes, and (2) file for a change in accounting method with the IRS. This election is irrevocable, so choosing this method should not be taken lightly. Not only is LIFO often more difficult to account for because it requires you to keep track of more pools of inventory, but it could negatively affect some of your key ratios that banks and investors look to in order to assess your business’s health.
None of what we’ve discussed today is easy, and there will never be a simple formula to decide what cost flow assumption you should use. However, combined with our previous article, we hope that you walk away with a better understanding of just what goes into inventory valuation. Your ultimate decision on how best to value your inventory will rely on a combination of business goals, compliance limitations, and realistic assumptions. Luckily, our GBQ Advisors are here to help. If you’d like to learn more about what we do, or if you have additional questions about how your inventory valuation practices are affecting your business, contact us directly. We look forward to speaking with you soon.