Question

LIFO vs. FIFO for costing inventory equalize overtime in much the same way that effects from differences in depreciation schedules equalize overtime. However, firms typically recognize deferred taxes related to depreciation, but not due to differences in LIFO vs. FIFO. Explain why a firm may not recognize deferred tax effects in connection with its choice of inventory costing assumptions. As part of your answer, be sure to indicate when a firm’s inventory costing assumption will cause recognition of deferred taxes

Answer 1

A company is allowed to maintain two separate sets of books for financial and tax purposes. Because the rules that govern financial and tax accounting differ, temporary differences arise between the two sets of books. This can result in deferred tax liability, when the amount of tax due according to tax accounting is lower than that according to financial accounting. Deferred tax liability commonly arises when in depreciating fixed assets, recognizing revenues and valuing inventories.

Differences in tax liabilities are simply temporary imbalances between a reported amount of income and its tax basis: The accounting disparities appear when there are differences between the taxable income and the pretax financial income or when the bases of assets or liabilities differ for financial accounting and tax purposes. For example, money due on a current receivable account cannot be taxed until collection is actually made, but the sale needs to be reported in the current period.

Because these differences are temporary, and a company expects to settle its tax liability (and pay increased taxes) in the future, it records a deferred tax liability. In other words, a deferred tax liability is recognized in the current period for the taxes payable in future periods.

A company is allowed to value their inventories based on the last-in-first-out (LIFO) method, while some companies choose the first-in-first-out (FIFO) method for financial reporting. During the periods of rising costs and when the company's inventory takes a long time to sell, the temporary differences between tax and financial books arise, resulting in deferred tax liability.

A deferred tax position can only be recognized if the future taxes payable event is "more likely than not" to occur. Deferred tax liabilities can be treated as equities or liabilities when they are recognized.

In instances where the more-likely-than-not element is no longer accurate for a deferred tax liability, the company must effectively cancel out the impacts of the deferment and report its effects in the earliest reporting period following the change. The company may need to do a write-down to correct previous financial statements, as long as the de-recognition of the liability creates material changes in the profit and loss statement or the income statement.