Demystifying LIFO: Towards Simplification of Inflation-Adjusted Inventory Valuation

Abstract

The last in, first out (LIFO) method of inventory accounting has been available to taxpayers for more than 50 years. The basic concept of LIFO is relatively simple: it reverses the normal assumed flow of costs (first-in, first-out or FIFO) by matching the costs of the latest purchases or production against current-year sales. During periods of rising costs, LIFO generally results in lower taxable income than the FIFO method because current-year increases in inventory costs are charged to cost of goods sold, rather than accumulated in ending inventory. Thus, LIFO provides protection from the effects on taxable income of rising inventory costs (hereinafter "inflation").
Like many other aspects of federal income tax law, the practical implementation of LIFO has often proved to be a complex task. Particularly difficult issues have arisen over the fundamental concept of measuring costs on a comparable basis over time for inventory affected by stylistic, technological, or other changes. The tax law currently lacks objective, determinate standards for ascertaining the proper LIFO cost of inventory items that change. Current standards rely on concepts of similarity, involving fine distinctions that are difficult to apply consistently and resulting in costly and burdensome controversies, with little promise of more determinate results. Moreover, efforts to simplify LIFO have not freed taxpayers from mystifying complexity in this area, as the available simplified methods are far from simple and are not viable alternatives for many taxpayers.