artificial inventory profit

he Last In, First Out inventory method has been hotly debated at the federal level
. Congress has threatened to outlaw the method as the Internal Revenue Service i
ntroduces laws and requirements that make using the LIFO method inconvenient at
best. Using the LIFO method of inventory means that when you count the cost of g
oods sold, you use the current price rather than whatever price you paid for the
specific inventory in stock. If the prices of those goods go up from your initi
al purchase, your cost of goods sold will read higher, thereby reducing your pro
fits and, as a result, your tax burden and access to credit. If the costs go dow
n, your profits may be artificially inflated.
Taxes
The primary reason that companies choose to use an LIFO inventory method is that
when you account for your inventory using the last in, first out method, you repo
rt lower profits than if you adopted a first in, first out method of inventory, kn
own commonly as FIFO. The lower the profits you report, the less taxes you have
to pay. To give you an idea of the magnitude of these savings, George Plesko, an
accounting professor at the University of Connecticut, calculates that the gove
rnment lost out on $18 billion in tax revenue from 1975 to 2004, before tax cred
its, thanks to LIFO.
Profits
Reported profits are lower in an LIFO environment because of the change in cost
of goods sold. To illustrate the concept of LIFO and its relation to reported pr
ofits, imagine that you purchase a widget for $10 that you later sell for $15. I
n six months, the price goes up to $12. When you write off the cost of goods sol
d, you would use the most recent price, or $12, under the LIFO inventory method.
As such, it would appear that you had only made a $3 profit.
Had you used a first in, first out inventory method, you would have used the price
you paid for the actual good sold, or $10, so you would report a profit of $5.
By using LIFO, your profit would appear to be reduced by $2, from $5 to $3, whic
h would effectively reduce the amount of taxes you have to pay.
Related Reading: Step-by-Step LIFO Method of Perpetual Inventory Systems
Changes in the Economy
Of course, the benefit of using the last in pricing for the cost of goods sold is
dependent upon how the price of an item fluctuates. For instance, companies that
hold inventory for long periods, such as sheet metal fabricators, may find that
holding inventory for several years to be advantageous and use as a way to hedg
e their profits for tax purposes. But prices could always go down. That widget t
hat costs $10 today could cost $6 tomorrow, especially if the economy takes a sh
arp downturn like that seen in the dot-com bubble burst or the more recent housi
ng bubble burst.
Reduced Earning
Further, when you use LIFO, you typically end up with depressed earnings. This m
ay be a good thing when it comes to paying your taxes but it can cast a wary sha
dow over your company when you present your financial statements, as you would h
ave to to investors, creditors, banks and suppliers. In this way, showing depres
sed earnings could hurt your chances of achieving funding or establishing a line
of credit.