Filed under Finance
by Jarred by Jargon | May 31, 2012
I need to learn about how to value my inventory. This mysterious process seems to force one to choose between two things known as LIFO and FIFO. Help!
Jarred by Jargon
Dear Jarred by Jargon,
Your query brings back fond memories of a pair of goldfish I once had named Lifo and Fifo. But, lest I digress further, let's see if we can simplify this high concept bean counter jargon.
Although computer-based inventory control systems allow you to track each individual inventory item, the IRS doesn't require it (yet). And, unless you're selling big stuff like locomotives or pipe organs, you can usually choose one of two identification methods (for most classes of small inventory items) that make broad assumptions about which items were sold and which remain in inventory. These two methods are known as the "first-in, first-out" (FIFO, pronounced fye-fo) and the "last-in, first-out" (LIFO, pronounced lye-fo) methods.
Be aware that the IRS frowns on the use of LIFO—a really good reason not to choose it—so if you'd prefer not to wade through this lengthy diatribe, just faithfully use FIFO for everything. The reason the IRS frowns on LIFO is that a business using FIFO accounting will show higher profits in a period of rising prices than a business using LIFO accounting. Since rising prices are almost always a given, FIFO gives the IRS a bigger profit to tax you on. (To further discourage you from using LIFO, the IRS requires you to ask permission to do so in writing on their Form 970!)
The FIFO method assumes that sales are made from the items that have been longest in the inventory. This conforms to the usual business practice of trying to sell the older items first, before they become obsolete, spoiled, or out-of-fashion. The LIFO method assumes that the most recently purchased items are the ones you sold, and the oldest items are still sitting in your warehouse or on your shelf.
My accounting professor illustrated this concept by using the example of a one-door vs. a two-door warehouse. A one-door warehouse would be a LIFO warehouse: You'd take deliveries of goods in the door, shove them to the back of the place to make room for more deliveries and, when a customer came along, sell him the goods nearest the door—last goods in, first goods out. A two-door warehouse would be a FIFO warehouse: You'd take the goods in the back door, run them through on a conveyor belt and sell them out the front door—first goods in, first goods out.
As we hinted above, a consequence of using FIFO is that if prices are generally going up over time, your gross income will be matched against the lowest-priced items in your inventory, resulting in higher net profits. In contrast, LIFO would match your gross income against the most expensive items in your inventory, resulting in lower net profits and, consequently, a lower tax bill. If your business and inventory are constantly growing over time, LIFO will generally be preferable. . .preferable, that is, for you the beleaguered taxpayer. But the price you'll pay is a ton of paperwork and the risk of an audit!
If you are just starting out and don't use LIFO to value your inventory, you may select either the cost or the lower-of-cost-or-market method of inventory accounting. But you need to use the same method to value your entire inventory, and you can't change to another method without the IRS's consent. In truth, the IRS is less concerned about which procedure you use than with your being consistent from year to year, so that your inventory method accurately reflects your income.