Fall 2011 issue of Horizons

Manufacturing & Distribution – continued

The consideration of this tax proposal could lead to a significant amount of income for the federal government, but would also lead to a significant amount of cash outflow for certain business owners. The LIFO inventory accounting method has been allowed under Section 472 of the Internal Revenue Code (IRS) since the 1930s and is a method used to determine a company’s closing inventory cost. LIFO inventory accounting may be applied to a taxpayer’s entire inventory or to specific parts of its inventory. The outcome of using the LIFO method can be significantly different than the outcome of using the first-in, first-out (FIFO) inventory accounting method, which is also allowed by the IRS.

Companies have successfully used the LIFO method for years as a tax deferral mechanism. In a period of rising prices for raw materials and other inputs to inventory, LIFO, compared to FIFO, results in lower inventory balances and higher cost of goods sold which ultimately decreases taxable income and increases tax savings. The LIFO method is routinely used by manufacturers, wholesalers, distributors, car dealerships, and retailers. Under the current IRS guidelines, if a taxpayer is authorized by the IRS to change from the LIFO accounting method to another allowable method, the taxpayer must recapture the financial benefit from using LIFO ratably over four tax years.

In addition, the taxpayer must then wait five years to re-adopt the LIFO method of inventory accounting.

Under the LIFO method, regardless of whether the goods on hand can be specifically indentified and matched against invoices, the goods on hand at the end of the year are considered to be those aquired earliest. Under the FIFO method, the goods on hand at the end of the year are considered to be those acquired most recent. Under either method, LIFO or

LIFO Versus FIFO in Periods of Rising Costs

Assume an oil distributor buys a barrel of oil for $100 and a few months later the distributor buys an additional barrel for $150. The distributor then sells one barrel of oil for $200 during the year. Below is a comparison of the taxable income and tax liability under both the LIFO and FIFO methods.

While it did not ultimately pass,

President Obama’s tax proposal earlier this year would have prohibited LIFO and required taxpayers to write up their inventory to FIFO value in the first tax year beginning after 2012. The resulting increase in income due to the write up will be taken into account ratably over 10

LIFO

FIFO

Revenue

$200.00 $150.00 $50.00

$200.00 $100.00 $100.00

COGS

Taxable Income

Corporate Tax Rate Tax Liability

41%

41%

$20.50

$41.00

FIFO, there is no difference in physical quantity of inventory, only the amount of costs allocated to the closing inventory. Since the valuation of a company’s closing inventory helps determine a company’s cost of goods sold, the valuation method used by a company affects its determination of taxable income.

years beginning with the first tax year after 2012.

Proponents for repeal of the LIFO method argue it preferentially allows certain taxpayers to defer tax on an indefinite or permanent basis. Other proponents for repeal say that LIFO has been burdensome and complex and has generated a good amount of controversy between the IRS and taxpayers.

Raise Your Expectations

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