Why Use FIFO for Taxes?

FIFO, First In First Out, calculates current inventory value by using the original purchase price of an item in inventory to determine its cost to the firm. Many businesses prefer LIFO, Last In First Out, because it uses the last purchase price of an inventory item to set its cost, which often reduces the amount of taxable income the business has to report. In some situations a company gains advantages when it uses FIFO for tax purposes.

LCM Disadvantages

The IRS also allows a business to use a method known as LCM, or Lower of Cost or Market, to report inventory purchase costs. A business can only use LCM for tax reporting if it knows the cost of each individual item or group of items in its inventory, which can be a major bookkeeping burden. According to the IRS, if the business mixes groups of items together that it purchases at different prices, it may not use LCM and must select either LIFO or FIFO.

Accelerated Depreciation

The business may qualify for accelerated depreciation. Under accelerated depreciation, a business can report a large depreciation expense in one tax year, greatly reducing its future tax liability. The business may want to report additional income using FIFO so that it can apply this depreciation expense to a large portion of its earnings.

Deflation

LIFO only reduces the taxable income of a business if prices are rising. In a period of deflation, when prices are dropping, the cost to purchase a new inventory item will be lower than the original cost of older inventory items. In some sectors, such as electronics and computer technology, prices typically drop over time as technology improves, according to the State University of New York at Suffolk.

Requirements

FIFO is simpler to use for tax reporting than LIFO. The IRS establishes additional income reporting rules for a business when it uses LIFO. The business will still have to calculate its income using FIFO, since it must also report its earnings to investors under the FIFO method when using LIFO, according to the University of Houston. A business that uses FIFO does not have to report the LIFO equivalent of its earnings on a financial statement.

Investors

FIFO increases the amount of income that a business can report to investors. FIFO reduces tax liability but it reduces the income the company reports as well. According to the University of Houston, investors often prefer a LIFO income report, but consider a FIFO inventory report to be better quality information.

References

• SUNY Suffolk: Inventory Valuation Methods
• The LIFO Coalition: To the President's Economic Recovery Advisory Board
• Internal Revenue Service: Inventory- Automotive Tax Tips
• University of Houston: Some Issues in Accounting and Implications for FSA