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Besides deciding how you will value your inventory at cost, or at the lower of cost or market you must also decide how you will identify which items were sold, and which are still in inventory. The most basic way of doing this is called the "specific identification method," in which you match each item sold with its cost (or market value).
The specific identification method is easy to understand, but may be totally impractical for your business. It may work well for companies that sell relatively few big-ticket items like cars or pianos. But if your business has a large, quick-moving inventory of smaller items, you soon would be doing little but tracking inventory if you had to do it piece by piece.
Although modern computer-based inventory control systems could allow you to track each widget, the IRS doesn't require it. Instead, you can usually choose one of two identification methods. These methods make broad assumptions about which inventory items were sold and which remain in inventory, without reference to the particular inventory items that were actually bought and sold. These two methods are known as the "first-in, first-out" (FIFO) and the "last-in, first out" (LIFO) methods.
The FIFO method assumes that sales are made from the items that have been longest in the inventory. This conforms to the usual business practice of trying to sell the older items first, before they become obsolete, spoiled, or out-of-fashion. This is also the method the IRS prefers.
In contrast, the LIFO method assumes that the most recently purchased items are the ones you sold, and the oldest items are still sitting in your warehouse or on your shelf.
One consequence of using FIFO is that if prices are generally going up over time, your gross income will be matched against the lowest-priced items in your inventory, resulting in higher net profits. In contrast, LIFO would match your gross income against the most expensive items in your inventory, resulting in lower net profits and, consequently, a lower tax bill. If your business and inventory are constantly growing over time, LIFO will generally be preferable.
The IRS does not favor LIFO and, if you want to use it, you must file IRS Form 970, Application to Use LIFO Inventory Method, and follow some very complex tax rules. There is also a "simplified" dollar-value LIFO method available to small businesses (those with average annual gross receipts of $5 million or less for each of the last three tax years). For more information, see your tax advisor.