How Your Inventory Accounting Method Could Save or Cost You Thousands in 2024 Taxes

As inflation continues to impact businesses across the country and tax regulations evolve, choosing the right inventory accounting method has never been more crucial for your bottom line. The recent surge in inflation has led managers to reassess the best inventory valuation methods—first-in-first-out (FIFO) or last-in-first-out (LIFO). In times of rising prices, FIFO typically results in higher earnings, while LIFO can reduce tax liabilities.

Understanding FIFO vs LIFO: The Basics

The LIFO inventory method allows companies to deduct the cost of inventory at the price of the most recently acquired items and assumes that the last inventory purchased is the first to be sold. The FIFO inventory method, by contrast, allows companies to deduct the cost of inventory at the price of the oldest acquired items and assumes the first inventory purchased is the first to be sold.

To illustrate the difference, consider a company with no beginning inventory that purchases three units of inventory over the course of the year: one for $30 in January, one for $31 in June, and one for $32 in November. The firm then sells one unit for $40 in December. If the company uses the FIFO inventory accounting method, it would deduct the cost of the first unit of inventory purchased, namely the unit purchased for $30 in January. Subtract $30 in costs from the $40 in revenue, and the company has $10 in income. Meanwhile, under the LIFO inventory accounting method, it would deduct the cost of the last unit of inventory purchased, namely the unit purchased for $32 in November. Subtract $32 in costs from $40 in revenue, and the company has $8 in income.

2024 Tax Implications: Why Your Choice Matters More Than Ever

FIFO and LIFO significantly impact tax obligations, particularly during periods of inflation. Businesses in the US often choose LIFO because of the LIFO Conformity Rule, which requires that if a company uses LIFO for tax purposes, they must also use it for financial reporting. This allows businesses to show lower profits and pay less in taxes, especially in inflationary periods.

The cost of goods sold tends to be lower under this method than under LIFO, resulting in higher taxable income and greater income tax liability. LIFO often is advantageous for federal income tax purposes. Under FIFO, COGS is lower and profits are greater, as is the income tax liability. With a higher COGS, profits and income taxes are generally lower under LIFO.

The Hidden Costs and Benefits

While LIFO can provide immediate tax benefits, it comes with important considerations. LIFO is not accepted under International Financial Reporting Standards (IFRS), making it illegal in many countries. LIFO is acceptable only under U.S. Generally Accepted Accounting Principles (GAAP). It’s not recognized under the International Financial Reporting Standards. You also have to formally elect to use LIFO on your federal tax forms, using IRS Form 970, “Application to Use LIFO Inventory Method.” Once you make the election, you can’t resume FIFO without IRS permission.

As higher inventory costs are used up, companies that use LIFO will need to start dipping into lower-cost layers of inventory, triggering taxes on “phantom income” that the LIFO method previously allowed the company to defer. This creates potential future tax obligations that businesses must consider in their long-term planning.

Making the Right Choice for Your Business

In some cases — particularly during periods of high inflation and stable inventory levels — adopting the last-in, first-out (LIFO) method could significantly reduce your taxable income and boost your cash flow. However, the decision isn’t purely about tax savings.

FIFO typically results in a stronger balance sheet than LIFO in an inflationary market because inventory values under FIFO are based on the most recently purchased items, FIFO usually boosts profits on your income statement, and cost of goods sold will generally be stable from one period to another. In general, companies that use the FIFO method appear financially stronger than they would if they used LIFO.

Professional Guidance is Essential

Given the complexity of inventory accounting methods and their significant impact on your tax liability, consulting with a qualified professional is crucial. Whether you need assistance with inventory method selection, tax planning, or compliance issues, working with an experienced accountant bloomington can help ensure you’re making the most advantageous choice for your specific business situation.

Regulatory agencies, like the IRS in the United States, require businesses to adhere to the same inventory method unless formally requesting a change. Such a change must be justified and approved to prevent companies from switching methods to manipulate earnings, tax liabilities or financial outcomes. Inconsistent application can lead to non-compliance with Generally Accepted Accounting Principles (GAAP), resulting in audits, penalties or reputational damage.

Looking Ahead: 2024 and Beyond

LIFO repeal would raise about $1 billion annually by reducing the COGS deduction alone. In addition, when a company elects to value inventory using LIFO, it must also report LIFO reserves which reflect the difference between inventory valued by the LIFO and FIFO methods, highlighting the ongoing policy discussions around these accounting methods.

As we navigate the current economic environment, businesses must carefully weigh the immediate tax benefits of LIFO against the potential long-term implications and compliance requirements. Your choice of accounting method for determining the value of your manufacturing company’s inventory can significantly impact your overall tax bill. The key is to work with qualified tax professionals who can analyze your specific situation and help you make an informed decision that aligns with both your short-term tax goals and long-term business strategy.

Remember, inventory accounting method selection is not just a one-time decision—it’s a strategic choice that will impact your business for years to come. Make sure you have the right professional guidance to navigate these complex waters successfully.