If you own a business that sells products, then part of your reporting responsibility includes calculating the value of your inventory. The two methods that are most frequently used are referred to as “LIFO” – Last In First Out — and “FIFO” – First In First Out. Each of these methods has its own advantages and disadvantages. Determining which is best for you will be based on many different aspects of your business and how it operates.
In this article we’ll take a look at the ways that you can value your inventory to help you decide which method makes the most sense for your business.
What Are FIFO and LIFO?
At their most basic, FIFO and LIFO are two different financial accounting methods used to monitor a business’ inventory and to calculate the cost of goods sold. Based on newly introduced rules contained within the Tax Cuts and Jobs Act, businesses that report $25 million or more worth of gross receipts are required to track inventory, and to use the accrual method of accounting. Those with gross receipts below this threshold are able to report their inventory as items being purchased for resale, or “non-incidental materials and supplies,” and to use the cash method of accounting.
The Importance of Inventory
Tracking inventory is an essential aspect of operating your business and determining profitability. Knowing what you have in your possession at any one time, plus the costs of purchasing and maintaining it, all contribute to calculating your cost of goods sold.
To make this calculation, you need to know:
Valuing your inventory and how much it costs is an essential piece of determining what your business’ tax liability will be. This is because it has a direct impact on your business’ profitability.
At the start of your fiscal year, you need to take inventory and value it using methods that conform to generally accepted accounting standards for businesses in the same or similar industries to your own. The IRS requires that you use the same valuation method from year to year, and that your inventory valuation must include an accurate and clear reflection of your business’ income.
Tracking inventory can be difficult, as it is a data point that is changing constantly. To address this dynamic, guidelines referred to as “Generally Accepted Accounting Principles” have been established. These include the following methods for establishing valuation:
Which Method Should You Use – FIFO or LIFO?
When trying to determine whether you should apply FIFO or LIFO for your business, the first question that you want to answer is what your goal is.
If you are trying to reduce your taxes, then you want to opt for the method that attributes the highest possible cost to your inventory and the lowest amount of profit – that would be LIFO, as it assumes that the higher cost items are the ones sold first.
However, most businesses prefer to use FIFO costing methods, particularly when inventory costs are decreasing. FIFO tends to be the most accurate reflection of costs, since in most cases older inventory items tend to cost less.
Making the decision on which accounting method is best for your business is a challenge, and not to be made without the assistance of a knowledgeable accounting professional who can advise you on both compliance and what will benefit you the most.
How Does the IRS View FIFO and LIFO?
Both the LIFO and FIFO accounting methods are legally acceptable and allowed by the Financial Accounting Standards Board (FASB) as part of its Generally Accepted Accounting Procedures. By contrast, LIFO is not permitted to be used by the body known as the International Financial Reporting Standards. This prevents companies that do business internationally from using it.
In the United States, the Internal Revenue Service allows the use of LIFO valuations despite the fact that it leads to lower taxable income and lower tax liability. Businesses that choose to use LIFO can do so by filling out Form 970, which must also be completed if a business chooses to change to LIFO after having used FIFO previously. Once this step is taken, a business is not permitted to switch back again unless it petitions the IRS for the right to do so.
Managing Inventory Via Periodic and Perpetual Inventory Methods
Whether a business uses LIFO or FIFO inventory valuation methods, it also must make a decision about its inventory management methodology. There are two preferred methods, and your choice will likely be based on the way that your business operates.
If you are a larger business, you will likely use point-of sale technology, which is referred to as perpetual inventory management, and which records sales and makes appropriate reductions to inventory automatically. Smaller businesses tend to manually count their inventory, using a method known as periodic inventory management.
It is also important to note that if you opt to use LIFO inventory valuations, you are likely to invest more time in tracking and managing inventory, as you end up counting older inventory items for longer periods of time and end up having to continually count and record them.
Seek Professional Assistance in Determining The Best Valuation Method For You
Choosing the right inventory valuation method is an important decision. It will have a significant impact on your business’ profitability and should be based on complex details that are specific to your operations. For assistance in making this choice, contact your accounting professional.
Frank Jenkins, CPA writes for CountingWorks, an accounting news and advice website. Reach him at [email protected].
About Frank Jenkins Jr
Frank Jenkins Jr. CPA is the managing partner of Adams, Jenkins & Cheatham, a CPA practice based in Midlothian, VA. Frank specializes in Consulting services, tax planning, audit & assurances. "I genuinely care about our clients because I have a personal connection with them." He is active in the community and belongs to the AICPA and the VSCPA.
