Repeal the "LIFO" and "Lower of Cost or Market" Inventory Accounting Methods

To compute its taxable income, a business must first deduct from its receipts the cost of purchasing or producing the goods it sold during the year. Determining those costs requires that the business identify and attach a value to its inventory. Most companies calculate the cost of the goods they sell in a year by adding the value of the inventory at the beginning of the year to the cost of goods purchased or produced during the year and then subtracting from that total the value of the inventory at the end of the year.

The tax code allows firms to choose from among several approaches for identifying and determining the value of the goods included in their inventory. For itemizing and valuing goods in stock, firms can use the “specific identification” method. That approach, however, requires a very detailed physical accounting in which each item in inventory is matched to its actual cost (that is, the cost to purchase or produce the item). An alternative approach—“last in, first out” (LIFO)—also allows firms to value their inventory at cost but, in addition, permits them to assume that the last goods added to inventory were the first ones sold. Under that assumption, the cost of those more recently added goods should approximate current market value (that is, the cost of replacing the inventory).

Yet another alternative approach—“first in, first out” (FIFO)—is based on the assumption that the first goods sold from a business’s inventory have been in that inventory the longest. Like firms that adopt the LIFO method, firms using the FIFO approach can also value their goods at cost. But firms that use the FIFO approach have still another choice—the “lower of cost or market” (LCM) method. Instead of assessing their end-of-year inventory at cost, they can assess that inventory on the basis of its market value and use that valuation if it is lower than the actual cost of acquiring or producing those goods. In addition, businesses that use the FIFO approach can qualify for the “subnormal goods” method of inventory valuation if their goods cannot be sold at market prices because they are damaged or flawed.

This option would eliminate the LIFO method of identifying inventory, as well as the LCM and subnormal-goods methods of inventory valuation. Businesses would be required to use the specific-identification or FIFO methods to account for goods in their inventory and to set the value of that inventory on the basis of cost. Those changes—which would be phased in over a period of four years—would increase revenues by a total of $102 billion over the 2017–2026 period, the staff of the Joint Committee on Taxation estimates.

The main rationale for this option is that it would align tax accounting rules with the way businesses tend to sell their goods. Under many circumstances, firms prefer to sell their oldest inventory first—to minimize the risk that the product has become obsolete or been damaged while in storage. In such cases, allowing firms to use alternative methods to identify and value their inventories for tax purposes allows them to reduce their tax liabilities without changing their economic behavior.

An argument for eliminating the LIFO method is that it allows companies to defer taxes on real (inflation-adjusted) gains when the prices of their goods are rising relative to general prices. Firms that use the LIFO method can value their inventory on the basis of costs associated with newer—and more expensive—inventory when, in fact, the actual items sold may have been acquired or produced at a lower cost at some point in the past. By deducting those higher costs as the price of production, firms are able to defer paying taxes on the amount their goods have appreciated until those goods are sold.

An argument against eliminating the LIFO method relates to the effects of inflation on taxable income. When inventories are valued on the basis of historical costs, price increases that occur between the time the inventory is purchased and the time its value is assessed raise taxable income. That effect tends to be greater with the FIFO method than with the LIFO method because the latter method values inventory by using the purchase prices of more recently acquired goods, thus deferring the effects of inflation on taxable income. However, other elements of the corporate income tax also treat gains that are attributable to inflation as taxable income.

An argument for eliminating the LCM method of inventory valuation under FIFO is that, when prices are falling, it provides a tax advantage for goods that have not been sold. The LCM method allows a business to compare the market value of each item in its end-of-year inventory with the cost to purchase or produce the item and then set the lower of the two as the item’s value. The year-end inventory will have a lower total value under LCM than under the cost method if the market value of any item in the inventory is less than its actual cost. Using the LCM method when prices are falling allows the firm to claim a larger deduction for the costs of goods sold, causing the firm’s taxable income to fall as a result. In effect, that method allows a firm to deduct from its taxable income the losses it incurred from the decline in the value of its inventory. (That deduction is allowed even though the firm has not sold the goods.) A firm, however, is not required to recognize gains in the value of its inventory when prices are rising, which means that gains and losses are taxed differently. Similarly, firms that use the subnormal-goods method of inventory valuation can immediately deduct the loss, even if the company later sells the good at a profit.

An argument against eliminating the LCM method for tax purposes is that it can simplify inventory valuations by those businesses. To the extent that firms find the LCM method a desirable method of inventory valuation, allowing them to use the same methodology for both financial accounting and tax purposes reduces complexity, particularly for small businesses.