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 using the accrual method of accounting, 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 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. 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 produced 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 existing inventory at cost, they can assess that inventory on the basis of its market value and then choose whichever valuation is lower. In addition, if a business's goods cannot be sold at market prices because they are damaged or flawed, firms that use the FIFO approach can qualify for the "subnormal goods" method of inventory valuation.
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 $72 billion from 2012 through 2016 and by a total of $98 billion over the 2012-2021 period.
The main rationale for this option is to align the tax accounting rules with how businesses probably sell their goods. Under many circumstances, firms probably prefer to sell their oldest inventory first--among other reasons, to minimize the risk that the product becomes obsolete or damaged during storage. Under those circumstances, allowing firms to use alternative methods to identify and to value their inventories for tax purposes allows them to reduce their tax liabilities without any change in their economic behavior.
An argument for eliminating the LIFO method is that it allows companies to defer taxes on real (inflationadjusted) gains when the prices of their goods are rising relative to general prices. Firms that use LIFO can assume that the goods that are sold are from newer--and costlier--inventory when, in fact, the items may have been in inventory for some time and were produced when costs were lower. By deducting those higher costs as the price of production, firms are able to defer taxes on the amount by which the value of their goods has appreciated, until those goods are sold.
An argument against disallowing the LIFO accounting method is that such a policy change could also result in the taxation of income that arises from inflation. The gains that would be taxed if the LIFO method was terminated could be attributable to inflation and, therefore, would not represent real changes in a firm's resources and its ability to pay taxes. However, other elements of the corporate income tax do not correct for inflation and therefore gains attributable to inflation are taxed.
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 inventory with the item's cost 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 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.