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LIFO, FIFO, and the Weighted Average

What Every Farmer, Rancher, and Vineyard Owner Must Know

Simply stated, there are two basic accounting systems used in the United States: Cash and Accrual.  The Cash Method of accounting recognizes income and expense when they are actually incurred.  The Accrual Method attempts to tie the cost of producing goods with the sales of those goods.  For example:

Joe Farmer raises oranges.  Typically, harvest occurs during January.  However, Mr. Farmer must plant, irrigate, spray, and weed each year before the harvest is ready.  This past year, his costs were $100 per acre incurred during 2012 for preparing his orchard, $100 per acre incurred during 2013 for harvesting his orchard, and he was paid $300 per acre during 2013 after harvest for his crop.

Using the cash method, Mr. Farmer would deduct the 2012 costs on his 2012 income tax return and his 2013 harvest costs on his 2013 income tax return.  All of his proceeds of sale would be recognized on his 2013 return.  Therefore, he would have a $100 loss in 2012 which might not be usable to reduce his taxes in 2012, and $200 in taxable net income on his 2013 return.

A different result would be reached using the accrual method.  Income and expenses would all be recognized in the same tax year.  Therefore, there would be no lost deductions and his taxable income would be more truly reflective of his actual $100 in net taxable income.

What really makes this interesting, and where the real tax savings lie, is that the Internal Revenue Code permits farmers, ranchers, and vineyard owners to use any accepted accounting method in stating income and expenses.  Thus, the concepts of LIFO, FIFO, and the weighted average must be considered:

  • LIFO allows “Last In First Out” inventory and associated expenses to be used to compute net income;

  • FIFO requires that the “First In First Out” inventory and expenses should be used; and,

  • “Weighted Average” means that all inventory costs and income for the applicable period will be averaged to compute net income.

Let’s apply these concepts to Joe Farmer’s situation.  If Joe’s preparation and harvest costs were each $100 per acre during 2012, but increased to $150 each per acre during 2013, a very different tax result would occur for his 2013 orange crop:

  • Under LIFO, the last incurred inventory costs would be used. Thus, for the $300 in sales, $300 in expense would be used and Mr. Farmer would have no net taxable income.

  • Under FIFO, the first incurred inventory costs would be used. Farmer’s net taxable income would be $100.

  • Under the Weighted Average, the average costs ($125 preparation and $125 harvest) would be used. Therefore, Mr. Farmer’s net taxable income would be $250.

It is important to note that in bad crop years, lower crop inventories will “dip into the cost reserve” and will result in higher stated profits and higher taxes.  However, in most normal years, with yield steady and costs increasing, tax savings should result.

This example demonstrates how a chosen accounting method will affect farm, ranch, and vineyard income.  Reducing or deferring income tax can be the difference between farming profitably and losing the family farm.  Acuña ❖ Regli can help you and your tax professional to operate your farm, ranch, or vineyard profitably and tax-effectively.

Acuña ❖ Regli provides expert services within the four corners of family wealth transfers: Estate Planning, Probate and Trust Administration; Conservatorship and Special Needs Planning; and, Inheritance Litigation.  We are also available to counsel our clients and to refer them to competent, qualified attorneys who can help if they need further, specialized help.  ContactUs@AcunaRegli.com or call (925) 906-1880.

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