What are the Tax Considerations in Choosing an Inventory Accounting Method? 

Because inventory costs affect net income, we just talked about that they inherently have potential tax effects.

Assuming that we're in an inflationary period, FIFO yields the highest net income. It's going to result in the company paying the highest amount of taxes. But, our assets are going to look good because they're going to be at a higher asset value - as lower value assets have been removed. 

LIFO will yield the lowest income, thus it will result in the company paying the lowest taxes. The tradeoff is, if it's an inflationary period, the asset value on my balance sheet will be lower. This can be less attractive to investors. 

Ultimately, companies don't need to choose this based on how much they they're paying taxes. They should do it based on what's more accurate in the accounting records.

Inventory Accounting Methods for Tax versus Financial Reporting

Companies can choose to use different methods for financial reporting purposes and tax reporting purposes. So, ideally, you would use FIFO for financial reporting and LIFO for tax reporting. Unfortunately, the IRS requires companies that choose to use LIFO for tax reporting purposes to also use LIFO for financial reporting purposes. This is called the "LIFO conformity rule". You can, however, use pretty much any other combination. 

Related Topics

• Do It Right the First Time (DRIFT) Definition
• What is Merchandise Inventory (Retail Inventory Method)? – Financial Accounting
• What are Inventory Costs (Carrying Costs)? – Financial Accounting
  
  • Obsolete Inventory Definition
  • Shrinkage (Inventory) Definition
• Specific Identification Method of Accounting for Inventory – Financial Accounting
• First-in, First-Out Method (FIFO) – Financial Accounting
• Last-In, First-Out Method (LIFO) – Financial Accounting
• Weighted-Average Method of Accounting for Inventory – Financial Accounting
• Financial Statement Effects (Inflationary vs Deflationary Periods) – Financial Accounting
• Intermittent Purchase and Sell
• Choosing an Accounting Method – Financial Accounting
• Effect of Each Accounting Method on Taxes – Financial Accounting
• Lower of Cost or Market Method of Accounting for Inventory – Financial Accounting