Many businesses hold inventories of goods, both inputs and products for sale. Because the purchase of inventory represents an exchange of cash for an equal value of assets, firms cannot deduct inventory when purchased. Instead firms deduct the cost of inventory against the sale of goods in computing net profit. Because otherwise identical goods moving out of inventory can have different costs, depending on when they were acquired, firms rely on specific conventions to account for the costs of goods sold.
Most companies use first-in-first-out (FIFO) which assumes that the goods first purchased are the ones first sold. The cost of the goods on hand at the end of the year, the firm’s inventory, reflects the most recent purchases. Alternatively, companies can elect to use last-in-first-out (LIFO) as long as they use the same method for financial statement purposes. This method assumes that the goods first purchased make up the firm’s inventory at the close of the year. If prices are rising, LIFO allocates higher costs to goods sold, which both reduces current income and assigns a lower value to the year-end inventory.
The Obama budget would repeal the election to use LIFO for income tax purposes. Taxpayers that currently use the LIFO method would be required to write up-that is, revalue-their beginning LIFO inventory to its FIFO value in the first taxable year beginning after December 31, 2011. This one time increase in gross income would be taken into account ratably over the first taxable year and the following seven taxable years.
Under LIFO, as long as sales during a year do not exceed purchases, all sales are matched against purchases in the same year and the opening inventory is never considered to have been sold. Therefore, a company that has used LIFO for many years will have a stock of inventory on its tax returns with a much lower value than its current acquisition price. Repealing LIFO and making companies pay tax on the accrued difference between the LIFO and FIFO valuations of its inventory would impose a substantial one time tax and a smaller permanent annual tax as long as prices are increasing. Ways and Means Committee Chairman Rangel has proposed in H.R. 3970 to allow firms to spread the income from the initial adjustment from LIFO to FIFO over 8 years.
Proponents of repeal argue that LIFO has no value as a management tool and serves only to cut tax liability for a relatively small number of firms. Opponents of repeal argue that LIFO makes the effective tax rate on inventory comparable to that on machinery and buildings and that repeal would overtax inventory. Further, they argue that in the presence of inflation FIFO taxes firms on profits that represent changes in the price level instead of real economic profits and that LIFO may represent a better approximation of real economic income. Proponets of repeal also point out that LIFO is currently prohibited under the International Financial Reporting Standards (IFRS).
Is It Time to Liquidate LIFO? Edward D. Kleinbard, George A. Plesko, and Corey M. Goodman, Tax Notes, October 16, 2006.
Why LIFO Repeal Is Not the Way to Go, Alan D. Viard, Tax Notes, November 6, 2006.
Description of Revenue Provisions Contained in the President’s Fiscal Year 2010 Budget Proposal; Part Two: Business Tax Provisions (JCS-3-09), Joint Committee on Taxation, September 2009, pp 72-75