How does lifo affect taxes

Domenici, R-N. The plan itself was removed from consideration almost as soon as it was proposed, but talk of LIFO repeal in Congress did not end and the issue was revisited in hearings before the Senate Finance Committee in mid- June.

This recent legislative interest in a targeted LIFO repeal raises the issue of whether LIFO should be permitted generally, a topic that has not been widely discussed in the tax policy literature. This report summarizes and critically analyzes the key arguments in support of LIFO inventory accounting.

We find that, as practiced today, LIFO accounting amounts to a massive tax holiday for a select group of taxpayers.

This tax holiday is inconsistent with larger income tax principles, cannot be justified even by the arguments usually advanced by its proponents, and is not supported by global best practices in financial accounting. We believe the proper response is for Congress to repeal the LIFO method of inventory accounting for tax purposes, preferably in the context of broad-scale corporate tax reform. Those figures underestimate the total LIFO reserve for all taxpayers using LIFO accounting, if for no other reason than because the data do not include privately traded firms.

For purposes of argumentation, we can cheerfully accept the LIFO Coalition's emendation of our estimate and maintain that it proves only that Congress is presented not with one tree bearing low-hanging tax fruit, but rather with an entire orchard ripe for the picking.

We demonstrate in this report that there simply is no room in a principled income tax for LIFO accounting. The purpose and effect of LIFO is to provide eligible taxpayers with a deduction for an expense that is never incurred. The author of the leading treatise on the taxation of inventories who is also the author of the memorandum submitted to the Finance Committee by the LIFO Coalition acknowledged exactly this point at the beginning of his treatise's discussion of LIFO accounting: The single most important factor that has influenced taxpayers to adopt the LIFO method is the tax savings that result from its use for tax purposes.

Theoretically, use of the LIFO method results only in a deferral of taxes. However, as long as inflation continues and a taxpayer's LIFO inventories remain relatively constant or increase in size, the tax deferral is perpetuated and tends to become 'permanent.

As such, it is inconsistent with the fundamental purpose of the income tax, which is to tax the entirety of a taxpayer's annual accretion to wealth, whether labeled "inflation-generated" or otherwise. LIFO fails another fundamental principle of a well-designed income tax in that it is not available to all taxpayers in all industries, but rather only to those that maintain physical inventories and are not required to use another accounting method for those inventories.

Thus, the services industries are almost entirely excluded from LIFO's tax holiday. Finally, LIFO serves no independent business or commercial purpose: As demonstrated below, companies that employ LIFO for tax purposes go to great lengths not to use LIFO for any observable nontax business purpose, such as capital budgeting or management compensation. The avowed purpose of LIFO is to permit taxpayers to defer inflation-related increases in inventory values. LIFO is described by its proponents as achieving a better matching than does first in, first out FIFO between current revenue and current expense, which in turn is said to further good tax policy, by "ameliorat[ing] the harmful effects of inflation on capital investment.

As the remainder of this report describes in more detail, however, that argument rings hollow, for several reasons. First, even taken on its own terms, LIFO accounting for inventory is overgenerous because it immunizes companies from paying tax on inventory gains attributable to factors other than inflation. Second, LIFO accounting is not analogous to accelerated depreciation or other timing benefits because LIFO accounting amounts in practice to permanent, not temporary, reductions in tax liability.

Third, unlike accelerated depreciation, LIFO does not provide broad-based benefits to all taxpayers with inventories. More fundamentally, Congress rationally could have decided to encourage the investment in productive plant or equipment, to increase the productivity of American businesses and the collective wealth generated by the economy.

As practiced, however, LIFO inventory accounting appears to encourage, through a tax subsidy, the systematic accumulation of inefficient levels of inventories, together with a mechanism to manage earnings reported to both shareholders and the tax authorities.

Our principal focus in this report is on tax policy, not financial accounting. We believe, however, that if LIFO were not permitted as a tax accounting method it quickly would be rendered extinct in the financial accounting landscape as well because LIFO, in practice, is a creature entirely of the tax ecosystem: The ecological niche it occupies is entirely that of a tax-savings strategy, not a robust alternative method to more fairly present companies' financial results. The remainder of this report is organized as follows.

Section II briefly describes the role of inventory accounting methods in an income tax and in financial accounting systems. Section III lays out our core arguments as to why LIFO accounting for inventories is fundamentally inconsistent with a principled income tax. Section V demonstrates that the "book- tax" conformity that purportedly serves as a governor on the adoption of LIFO is illusory.

Section VI describes how LIFO accounting can give rise both to poor physical inventory management and to financial accounting earnings management. Inventory Accounting Methods To understand the arguments that follow, it is helpful to review briefly how LIFO and other inventory accounting methods operate. Physical inventories generally are necessary to run a business that depends on the steady sale of similar goods to customers.

The existence of physical inventories in turn means that a taxpayer typically is simultaneously selling its goods to the public and buying or manufacturing replacement goods — its inventories. A taxpayer's net annual income from the sale of goods that it manufactures or purchases for resale simply equals its sales revenues minus its "cost of goods sold.

Every practical inventory accounting method makes that determination by adopting an arbitrary ordering rule that assigns in some mechanical fashion the costs incurred by the taxpayer during a year to manufacture or purchase for resale the goods that it sells to the public to 1 the goods that the taxpayer in fact sold during the year that is, to the "cost of goods sold" and 2 to the taxpayer's goods remaining on hand that is, in inventory at the end of the year.

Inventory accounting methods thus provide a cost flow assumption that in no way needs to relate to the physical flow of goods produced and sold by a business. Allocating a greater proportion of the taxpayer's total costs for the year to the cost of goods sold during the year reduces current income and simultaneously reduces the value assigned to the taxpayer's year-end inventories. FIFO's arbitrary ordering rule for inventory costs is that the taxpayer's inventoriable goods are deemed to have been sold in the order purchased or manufactured ; the costs associated with acquiring those goods are tracked as prices change, and the earliest first costs incurred are assigned to the goods sold during the year.

As a result, the taxpayer's ending inventory is deemed to comprise the taxpayer's most recently purchased or manufactured goods. A collateral consequence of FIFO's ordering rule is that FIFO tends to value inventories on hand at year-end at levels that approximate their market values replacement cost.

That result is consistent with underlying income tax principles because those principles seek to include in income net annual increases in a taxpayer's wealth, to the extent those increases are visible and quantifiable through "realization" events. LIFO's arbitrary ordering rule is the opposite of FIFO's: It assumes that the taxpayer sells the most recently purchased or manufactured inventoriable goods first, so that the taxpayer's first-acquired inventories are deemed never to be sold unless the taxpayer shrinks its inventories below historic levels.

In a world of increasing prices and constant or increasing inventory levels, a taxpayer that employs LIFO inventory accounting will report less income than an otherwise identical taxpayer employing FIFO because the LIFO firm will match its sales revenues against its most recently purchased or manufactured and therefore most expensive inventory costs.

The difference in the amounts of income reported using FIFO or LIFO in turn is offset by the difference in the values of the inventories a business reports under the two methods on its balance sheet. A taxpayer that employs LIFO carries its year-end inventories at values that can relate back to the taxpayer's adoption of LIFO —- a date that often is decades in the past.

For example, a taxpayer that adopted LIFO in and that has not shrunk its inventory levels since that date will carry its core inventories at values equal to their cost. When a taxpayer employs LIFO, "the day of reckoning is put off until the cost of replenishing the taxpayer's inventory or its volume declines. That difference is referred to as the LIFO reserve or inventory valuation allowance. The value of the LIFO reserve represents the cumulative amount of additional costs that have been expensed by the firm because of the choice of LIFO over its alternatives.

First, LIFO accounting's theme of "matching current revenues to current expenses" directly violates the principle that our income tax requires a taxpayer to account annually for the income that is, all increases to the taxpayer's wealth, to the extent those increases are observable the taxpayer derives during a year.

LIFO accounting for inventory fails that standard because it typically yields a permanent deferral of tax — the equivalent of a deduction for a cost that is never incurred. Second, even if LIFO were restricted in application to purely inflationary gains which is not the case, as Section IV demonstrates , LIFO violates another fundamental tax principle because it is a selective partial immunization from inflation — one that is neither available to all taxpayers, nor applicable to all similar assets, in a consistent manner.

The first part of this section expands on those two themes. Congress of course often deviates from rigid income tax theory to advance a larger economic or social agenda.

The second part of this section demonstrates, however, that there is no countervailing business or economic rationale that can excuse LIFO's failures. LIFO and Our Income Tax One point on which even proponents of LIFO accounting agree with us is that the practical effect of LIFO accounting is to grant a taxpayer that uses the method a permanent deferral — a tax holiday — in respect of the income attributable to increases in the value from whatever source of inventory assets during the period held by the taxpayer.

According to Boris Bittker and Lawrence Lokken, "For taxpayers anticipating long-term inflation in their industries, LIFO is an appealing option because its effect is to postpone tax on inflationary gains in inventory indefinitely.

Those proponents seek to justify that result, however, on the basis that "when the proceeds of sale of an inventory item are reinvested in a corresponding replacement item of inventory, there has been no genuine economic realization event.

Unfortunately for the proponents of LIFO, however, there in fact is a realization event when inventories turn over — a sale of property for cash. An important principle of our tax code is that income must be accounted for annually.

We honor that principle, for example, by requiring that tax be paid in the same year that income is "realized" and recognized by selling property. We do not allow businesses to avoid tax liability arising from the sale of property at a profit merely on the basis that the profit has been reinvested in more business assets — that is the essence of a consumption tax, not an income tax.

Yet that is exactly the result that proponents of the LIFO status quo seek to preserve for themselves. Returning to the earlier discussion in Section II, it might be argued that because both FIFO and LIFO are themselves arbitrary inventory ordering rules, objections to LIFO amount to nothing more than an arbitrary preference for the method that maximizes tax liabilities.

To the contrary, FIFO in fact more clearly coincides with income tax principles. We are agnostic, however, on the question of which inventory accounting method — other than LIFO — most accurately reflects the goals of GAAP accounting.

Regardless of the method that a taxpayer employs to account for its inventory, the taxpayer in fact owns an asset the inventory itself. An ideal income tax would measure the values of a taxpayer's assets at the end of the year, compare those values with the corresponding values at the beginning of the year, and include the difference in income.

Another way of seeing that fundamental point is to imagine two otherwise identical taxpayers, one of which employs LIFO accounting for its widgets in inventory, and the other of which has perfected "just in time" JIT physical inventory management, to the point where it never has any inventories on hand. Yet LIFO accounting treats the two taxpayers identically — as if the first enjoyed no greater accretion to wealth for its tax year than did the second.

In summary, the LIFO method partially suspends the application of the realization principle for some sales of property LIFO inventories for cash — and by doing so, deviates from a comprehensive effort to capture in the taxpayer's annual income current increases in a taxpayer's wealth including increases in the value of inventories, like any other property , as documented through actual realization events.

By turning sales of inventory for cash into effective tax-free exchanges, LIFO accounting for inventories functions as an effective tax holiday for those firms that employ it. In short, in this fundamental respect LIFO accounting produces results directly in opposition to the purpose of an annual income tax. A second-order failing of LIFO when measured against income tax principles is that, even if it were restricted to accomplishing its purported objective of immunizing taxpayers only from purely inflationary inventory gains which in fact is not the case, as demonstrated in Section IV, below , that objective would not be sufficient because it would be underinclusive.

That is, this idealized inflation-immunization program would be available only to some taxpayers in some businesses — those with physical inventories and that are otherwise eligible for LIFO accounting. Inflationary gains are not unique to inventories, yet even an idealized LIFO accounting system would reach only one class of assets.

Any time the code privileges one class of assets over another, it distorts economic behavior. In this case, the distortion is to encourage taxpayers to maintain physical inventories beyond the levels they might otherwise need, simply to avoid recognizing layers of built-in and as-yet indefinitely deferred LIFO inventory gains.

We return to this theme in Section VI. To be clear, inflation is a very important issue in the design of any income tax system. Our tax system today largely deals with inflation by ignoring it, at least explicitly with the exception of some tax bracket adjustments and the like.

Our point in criticizing the argument that LIFO appropriately responds to inflation concerns is not to trivialize the importance of inflation, but rather to maintain that ad hoc and selective solutions like the LIFO accounting method distort economic decisionmaking even more than does not addressing the issue at all.

It might be argued that the LIFO method is a completely acceptable inventory accounting method under U. GAAP, which surely must mean that we must be mistaken in our argument that LIFO accounting is inconsistent with a principled income tax. It is true that LIFO is a recognized GAAP accounting method, but that fact does not mean that its purpose or effect necessarily is consistent with the goals of our income tax system.

As the Supreme Court explained in a case dealing directly with inventory valuation methods, appropriate or at least permissible financial accounting inventory methods sometimes conflict with the design and purpose of our income tax. In those cases, the financial accounting method must be rejected for tax purposes. In sum, once one sees LIFO for what it is — an ersatz basis indexation scheme available only to some taxpayers in some businesses — it becomes apparent that LIFO functions as just another preferential tax break available only to some taxpayers, but paid for by all, through the higher tax rates needed to raise the same aggregate revenues.

LIFO is demonstrably inferior to FIFO in the core income tax objective of capturing a taxpayer's annual accretions to wealth, whenever those accretions are observable, and even a hypothetical idealized version of LIFO would distort economic decisionmaking through its incomplete scope. LIFO Is Not Justified by Other Goals If the code perfectly embodied only idealized income tax principles, it would be much shorter in length, but draconian in application.

Congress frequently and consciously deviates from those principles to accomplish goals of administrative simplicity, or of fairness, or to encourage activities that are thought to advance larger economic or social agendas. Proponents of the LIFO status quo have argued that LIFO accounting results in a timing benefit, and as such is analogous to accelerated depreciation or other timing benefits conferred by Congress. In fact, the analogy is inapposite, for two reasons.

First, as the preceding section demonstrated, in practice LIFO accounting operates as a permanent or near permanent deferral of tax liability — a true tax holiday. Second, and more fundamentally, what larger purpose is served by maintaining historic levels of inventories, simply to avoid LIFO recapture? Congress provides incentives for investment in productive plant and equipment because those investments improve the productivity of a broad range of American businesses, and with it the wealth of all Americans.

None of us wins, however, by having capital tied up in inventories simply to perpetuate LIFO accounting's indefinite tax deferral scheme.

Since prices tend to rise rather than fall over the long term, then using FIFO will generally produce a larger profit which in turn means a larger tax bill.

In periods of inflation, companies often wind up with products in their inventory that are identical but that cost them different amounts.

For example, say you own a grocery store. The bottles are identical. This creates a problem when you sell a bottle of ketchup, because you must include the cost of that bottle to your cost of goods sold, or COGS expense.

It's not practical to track each individual item of inventory when the items are identical, like bottles of ketchup.

So companies typically set a policy of assuming that when it sells a product, the item that comes out of inventory was either the oldest one there or the newest one. In the former case, the company is using the "first in, first out" method, or FIFO. In the latter case, it's using "last in, first out," or LIFO.

Other countries have countered and imposed tariffs on U. These trading policies have led to some uncertainty in the marketplace. Without getting into the issues of whether or not to impose tariffs, and if so, on what products and in what amounts, one opportunity that emerges from these higher prices caused by the tariffs is the possible use of LIFO. Higher product prices in certain industries, whether caused by tariffs, the threat of tariffs, or other reasons may generate a larger LIFO benefit.

For companies already using LIFO, they should look at their situations closely to see if higher inflation exits in will have more of an impact. Next, there are several alternative LIFO methods to choose from with varying complexities and tax benefits. The IPIC method reduces complexities as it measures inflation based on published indexes that are tracked and maintained by the U.

The inflation determined by the BLS indices is used instead of measuring inflation based on changes in actual costs for each inventory item of a business.

The IPIC method sometimes results in higher inflation than a company is experiencing internally. LIFO is different from other types of accounting methods. In fact, it has its own unique form Form and set of rules. LIFO may not make sense in every situation, and it is always easier to make an informed decision with an actual cost vs. Next, as noted above, the business must also be willing to use LIFO for financial statement reporting purposes—this is a key consideration in the LIFO analysis.

This publication contains general information only and Sikich is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or any other professional advice or services. This publication is not a substitute for such professional advice or services, nor should you use it as a basis for any decision, action or omission that may affect you or your business.

Before making any decision, taking any action or omitting an action that may affect you or your business, you should consult a qualified professional advisor. You acknowledge that Sikich shall not be responsible for any loss sustained by you or any person who relies on this publication. This field is for validation purposes and should be left unchanged.

Upcoming Events. November 18 pm - pm CST. November 23 am - am CST. December 1 am - am CST. December 2 pm - pm CST. Latest Insights. PSA — How to view who is signing into your Microsoft account. November 12, ASC remains effective, with no delay in implementation date. November 11, View All Insights.