The way businesses value inventory can affect their taxes. It also affects the financial statements companies present to banks when they apply for loans. Businesses generally are allowed to use one method for their taxes and another for their financial statements. Although this can get complicated, choosing the best option for your business may allow you to achieve different business goals.
Cost of Goods Sold
Inventory is not directly taxable unless it’s sold. Its value, however, is taxable because it is considered to be part of your company’s net profit. Put another way, the inventory in your warehouse isn’t taxed while it is there, but the cost of buying and selling it is part of the calculation of the cost of goods sold and reported as part of your company’s taxable profit.
The cost of goods sold is calculated using this formula:
Cost of goods sold = starting inventory + purchases/additions – ending inventory + nondeductible items for personal use
That means your company needs to keep careful track of the number of items you buy and sell during your tax year as well as your ending inventory.
Although there are other ways to calculate the cost of goods sold, most businesses use either the first-in-first-out (FIFO) or last-in-first-out (LIFO) method of accounting to value their inventory. FIFO means the items purchased first are sold first. It is the exact opposite of LIFO (last-in-first-out), which means the last items purchased are the first sold. FIFO is the most commonly used method in the United States, but that doesn’t mean it’s the best choice for your business.
If you expect the cost of your products to go up over time, for example, your taxes may be lower if you use LIFO, but you may have a harder time getting a bank loan because of the way inventory is shown on your financial statements.
Pros and Cons of the Methods
Both systems have pros and cons. To decide which method to use, consider the following:
- Your costs. When costs are rising, the oldest items in your warehouse are the least expensive and the newest are the most expensive. Using FIFO, your profits will be higher and so will your income taxes. The reverse is true if costs are decreasing. If you use FIFO, the oldest items in your inventory will be the most expensive, increasing the cost of goods sold. Your taxes will be lower.
- Materials flow. Generally, businesses use what they have before they order more inventory.
- Financial reporting. For businesses operating internationally, the International Financial Reporting Standards (IFRS) doesn’t accept the use of LIFO. IFRS rules are based on principles rather than exact guidelines. The IRS allows LIFO reporting, but there are stipulations.
- Price fluctuations. Using FIFO, inventory is continuously used up. That is not always true of LIFO because older inventory is always on hand. Using an alternate costing method, such as the average cost method, your average cost during the period is assigned to all items and price fluctuations aren’t a factor.
Inventory plays an important role in your business’s overall financial picture. If you have questions, contact an MCB Advisor at 703-218-3600 or click here. To review our business planning articles, click here. To review our tax news articles, click here. To learn more about MCB’s tax practice and our tax experts, click here.