If your business sells items from inventory, you must decide which methods you will use to assign costs and value inventory. In fact, you have to make the decision twice, once for your financial reporting, or book accounting, and again for your tax accounting. The Internal Revenue Service is perfectly fine with your using different methods for each.
Under the first-in-first-out cost flow assumption, you assign your earliest costs to your inventory first. Under normal economic conditions, prices rise over time, so FIFO minimizes your cost of goods sold, or COGS. The inventory equation says ending inventory equals beginning inventory plus inventory purchases minus COGS. By minimizing COGS, FIFO gives you a higher value for ending inventory. You have greater gross profits -- sales minus COGS -- under FIFO, as well as higher current assets, which includes inventory. This might be good for financial reporting, as it emphasizes your profitability, but is not so good for tax reporting because it creates higher taxable income.
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A money-saving tactic is to select FIFO for your financial reporting and last-in-first-out for taxes. LIFO assigns the latest costs to inventory first and therefore gives results opposite to those of the FIFO cost assumption. In normal economic conditions, using LIFO for your tax reporting minimizes your taxable income. If you choose LIFO for taxes and FIFO for financial reporting, you usually report the excess of FIFO inventory over LIFO as your "LIFO reserve." To use LIFO for tax reporting, you must file IRS Form 970 in the year you adopt this method. The term "LIFO" actually applies to a variety of submethods, such as dollar-value LIFO. You must apply for permission to change from one type of LIFO to another by filing IRS Form 3115.
Another set of choices involves how you will value inventory for financial reporting and taxes. Under the cost method, you assign value to your inventory based on its purchase cost, adjusted for discounts; transportation; and other charges. If you manufacture your inventory, include direct costs and all associated indirect costs. In the "lower of cost or market" method, you reduce the value of inventory for merchandise that fetches a price below your cost. Under the retail method, you calculate your COGS as a percentage of your sales revenue, then calculate ending inventory using the inventory equation.
The IRS prefers you use the specific identification method when possible, instead of LIFO or FIFO. This method has you assigning costs to each individual inventory item. The method is only feasible if you sell high-ticket items, such as cars and furs. You have more choices of inventory methods for financial reporting than those that the IRS allows for taxes. For example, you can assign average costs to your merchandise instead of LIFO or FIFO. In addition, you can adopt the gross profit method to value your inventory for financial reporting, but not for taxes. IRS tax reporting also rules out the combination of the LIFO cost flow assumption and the "lower of cost or market" method for valuing inventory -- if you pick one of these, you can't use the other.