Under the inventory valuation method called "lower of cost or
market" (LCM), businesses may deduct immediately the accrued losses on year-end
inventories but defer paying tax on gains until the year of sale. That situation
provides favorable tax treatment, although only to firms using the first-in,
first-out method of inventory accounting. Furthermore, under either the LCM or
the cost method of inventory valuation, firms may deduct immediately any losses
from inventory goods that arise from damage, imperfections, broken lots, or
certain other causes (subnormal goods method). In that case as well, firms
receive favorable tax treatment to the extent that such goods are sold--and
hence income is realized--in later tax years.
This option would repeal LCM and the subnormal goods method of
inventory valuation for all firms with gross receipts averaging more than $5
million annually over a three-year period. It would therefore require the
businesses to value their inventories at cost and include in taxable income both
gains and losses from the change in inventory value only when those goods are
sold. The Administration proposed this option in its past four budgets.
LCM not only causes a timing mismatch between recognition of
gains and losses, but it also has two mechanical shortcomings. First, once a
firm has reduced the value of inventories using the LCM method, it need not ever
record an increase in the value, even if the actual value of the inventories
subsequently rises. Second, the definition of market value is somewhat skewed.
Retailers are allowed to deduct losses on inventory following a markdown of the
retail price, even if the new retail price remains above the original cost.
Those shortcomings could be addressed, however, without repealing the LCM
method.
This option would increase revenues by $2 billion over the
2000-2009 period. The increase in liability has two components--a one-time
increase from the revaluation of existing inventory to exclude unrealized
(accrued) losses and a smaller, permanent increase from growth in the excluded
losses over time. Because the option phases in the new rules, the one-time
revaluation component raises liability every year for four years. The permanent
component increases over time because unrealized losses grow annually
