Repeal the “LIFO” Approach to Inventory Identification and the “Lower of Cost or Market” and “Subnormal Goods” Methods of Inventory Valuation
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
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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. Most companies calculate the cost of those goods 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. To determine the value of its year-end inventory, a business must distinguish between goods that were sold from inventory that year and goods that remain in inventory.
Businesses can choose between several approaches to identify and determine the value of items in their inventory. Under one approach, the specific-identification approach, firms itemize and value goods by tracking each item in inventory and matching it to its actual cost. Other approaches do not require firms to track specific items. The “last in, first out” (LIFO) approach permits them to assume that the last goods added to the inventory were the first ones sold; the “first in, first out” (FIFO) approach allows them to assume that the first goods added to their inventory were the first ones sold.
Firms that use the FIFO approach or the specific-identification approach can then value their inventory using the “lower of cost or market” (LCM) method. The LCM method allows firms to use the current market value of an item (that is, the current-year cost to reproduce or repurchase it) in their calculation of year-end inventory values if that market value is less than the cost assigned to the item. In addition, businesses can qualify for the “subnormal goods” method of inventory valuation, which allows a company to value its inventory below cost if its goods cannot be sold at cost because they are damaged or flawed.
This option would eliminate the LIFO approach to identifying inventory, as well as the LCM and subnormal-goods methods of inventory valuation. Businesses would be required to use either the specific-identification or the FIFO approach to account for goods in their inventory and to set the value of that inventory on the basis of cost. Those changes would be phased in over a period of four years.