LIFO Software and Consulting Services
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GLOSSARY OF LIFO RELATED TERMS:
Accounting and financial professionals who work with LIFO need to understand the jargon associated with LIFO. Below are a number of LIFO-related terms.
LIFO - This is an acronym for “last in, first out” which is a cost flow assumption used to value inventories. LIFO assumes that goods sold are those purchased most recently and that goods remaining in inventory at period end are those acquired in chronological order since the company adopted LIFO. This seldom matches the actual physical flow of goods. The theoretical justification for LIFO is that it matches goods sold during the current period with the cost of goods most recently purchased.
Compared to alternative inventory valuation methods (FIFO & average cost), the effect of using LIFO in times of rising prices is that the value of the most-recently purchased, higher cost items are included in the Cost of Goods Sold while the older, lower cost goods remain in inventory. In other words, LIFO is designed to move some of the inflationary costs from the balance sheet (inventory) to the income statement. This results in a lower inventory valuation, higher Cost of Goods Sold and lower taxable income.
FIFO - This is an acronym for “first in, first out” which is an accounting method for determining the cost of inventories. Under this method, the first items purchased are treated as being the first items sold. Period end inventories are valued using the unit cost of the last purchases made on an item-by-item basis.
Average cost - An inventory valuation method for which inventories are valued at an average of unit cost calculated for each inventory item. While there are several average cost calculation methods, the most commonly used for modern inventory accounting systems is a moving average in which the average unit cost is recalculated with each inventory purchase for each item.
Current-year cost - A term used by the IRS which describes the year end inventory balance that is to be converted to base year prices for companies using the dollar-value LIFO method. The current-year cost is usually the general ledger balance (for each LIFO pool) adjusted to exclude valuation reserves and to include adjustments for in-transit goods, shrink reserves, vendor discounts and other cost adjustments. The general ledger balance will usually be inventories stated at FIFO or average costs. There are four different current-year method alternatives allowed by the IRS in Reg. § 1.472-8(e)(2)(ii).
Lower-of-Cost-or-Market (LCM) - Another term for market write-downs. The IRS requires market write-downs to be eliminated for LIFO inventories in Reg. § 1.472-2(b).
IPIC Method - The Inventory Price Index Computation (IPIC) method was authorized by IRS Reg. § 1.472-8(e). This method permits taxpayers to use published government inflation indexes(external indexes) to calculate inflation for purposes of valuing LIFO inventories.
Simplified LIFO - The IPIC method is commonly referred to as “Simplified LIFO”. Simplified LIFO is actually a term the IRS used to describe a more simplified LIFO method applicable only to very small businesses provided for in Reg. § 1.474 starting in 1981 but this Section became superseded after 1986.
BLS - The Bureau of Labor Statistics, a division of the Department of Labor. The BLS publishes Consumer Price Indexes (CPI) in the monthly CPI Detailed Report. It also publishes Producer Price Indexes (PPI) in the monthly PPI Detailed Report. These published indexes are those used for IPIC method LIFO calculations.
LIFO Reserve - This is the difference between the FIFO value of inventory and the LIFO value of inventory (LIFO Reserve = FIFO – LIFO). The LIFO Reserve is a measure of the cumulative amount that a company’s taxable income or financial reporting pre-tax income has been reduced by using LIFO since the method was first adopted. The general ledger contra asset account(s) used to record this difference is also referred to as the LIFO reserve.
Negative LIFO Reserve - This occurs when the LIFO inventory balance is greater than the FIFO inventory balance.
LIFO Expense - This is the difference between the current period’s LIFO Reserve and the previous period’s LIFO Reserve (LIFO Expense = current period’s LIFO Reserve – previous period’s LIFO Reserve). This is the amount that taxable income or financial reporting pre-tax income has been reduced by for the current period by using LIFO.
LIFO Income - This is a term used to describe a change in the LIFO reserve that results in income (prior year reserve exceeds current year reserve). LIFO income results from either a LIFO decrement, current year LIFO deflation or a combination of both. For companies using Retail LIFO, LIFO income can also be a result of higher gross profit margins.
LIFO Pools - For taxpayers using the dollar-value LIFO method, all inventory items included in the LIFO election scope are separated by type of item. Similar items are grouped together to establish separate pools. There are several different methods of grouping inventory items into LIFO pools allowed by the IRS in Reg. § 1.472-8(b), (c) & (d).
LIFO Increment - The excess of the current period’s inventory at base minus the previous period’s inventory at base. This is also referred to as a “layer”.
LIFO Decrement - The excess of the prior period’s inventory at base minus the current period’s inventory at base. Decrements result in reduction or “erosion” of increments or layers created in earlier years and therefore a LIFO layer is not created for years that have decrements. A LIFO decrement is not the same as a decrease in the LIFO reserve compared to the prior year LIFO reserve (this is referred to as LIFO income).
LIFO Layer - A LIFO layer is the same as a LIFO increment.
LIFO election scope - The inventories for which the LIFO method is used. Neither the IRS Regs. nor GAAP requires that the LIFO method be used for all inventories if the LIFO method is used. Situations for which the LIFO election scope does not encompass all inventories are referred to as “partial” or “selective” LIFO elections.
LIFO conformity - The “LIFO conformity” rules are that section of the IRS Regs. (IRS Reg. § 1.472-2) that requires the use of the LIFO method for financial reporting purposes for those inventories for which the LIFO method is elected for tax purposes.
LIFO Index - A ratio expressed in decimal format that is the measure of LIFO inflation for each LIFO pool for taxpayers using dollar-value LIFO.
Current year LIFO Index - A LIFO index that is the measure of LIFO inflation for the current year only. Current year LIFO indexes are used for link-chain method LIFO calculations.
Cumulative LIFO Index - A LIFO index that is the measure of LIFO inflation from the base year to the current year end. For double-extension method LIFO index calculations, the cumulative index is calculated by dividing the sum of extensions at current year end prices (current year end on-hand quantity times current year end unit price) for all items or a representative sample of items by the sum of extensions at base year prices (current year end on-hand quantity times base year end unit price) for all items. For link-chain method LIFO index calculations, the cumulative index for the current year end is calculated by multiplying the cumulative index for the prior year end times the current year LIFO index. The current year link-chain LIFO index is calculated by dividing the sum of extensions at current year end prices by the sum of extensions at prior year end prices. Cumulative LIFO indexes are used to convert (by division) the current-year end inventory cost to base year dollars which is then compared to the prior year end inventory at base dollars to determine whether there is an increment or decrement for the year.
Dual Indexes - A method for which the deflator and inflator indexes are not the same. Dual Index methods are no longer (since 2002) allowed by the IRS. When they were allowed, some companies used dual indexes to achieve a lower LIFO inventory valuation by using inflator indexes that reflected beginning of the year rather than end of year prices. There are no GAAP rules that preclude the use of dual indexes.
Internal index - A term used to describe a non-IPIC index calculation method which entails using that company’s actual unit prices to calculate LIFO indexes.
Published or External index - The use of indexes published by the federal government to calculate LIFO indexes. The LIFO methods that permit the use of published indexes are the IPIC method available to all taxpayers and the BLS Department Stores Index method available only to department or discount store retailers.
Deflator index - LIFO index used to convert or “deflate” current year cost inventory balances to inventory at base year price values.
Inflator index - LIFO index used to multiply times (or “inflate”) layer (or increment) at base prices to produce a layer valued at LIFO cost. The inflator index used to value layers will be the same as the deflator index except, when a dual index method is used.
Category Inflation Index - This is a term used in IRS Reg. § 1.472-8(e) to describe the LIFO index for a particular CPI or PPI category.
Inventory Price Index (IPI) - This is a term used in IRS Reg. § 1.472-8(e)(3)(i) to describe a pool’s weighted average index for taxpayers using the IPIC method. For link-chain taxpayers, a pool’s IPI is multiplied times that pool’s previous year’s cumulative deflator index to produce the current year’s cumulative deflator index, which is then used to “deflate” current year cost balances to base year prices.
Weighted Harmonic Mean - The math prescribed by IRS Reg. § 1.472-8(e) to calculate weighted average pool indexes for the IPIC method. Weighted Harmonic Mean math entails “deflating” current year cost balances to prior year prices by division of the current year cost by the current year inflation index for that CPI or PPI index category to determine a Harmonic Mean “extension”. The pool index is calculated by dividing sum of the current year cost for all index categories by the sum of the Harmonic Mean extensions.
Weighted Arithmetic Mean - A method for calculation of weighted average pool indexes whereby current year cost balances are multiplied times the current year inflation index for that CPI or PPI index category to determine an Arithmetic Mean “extension”. The pool index is calculated by dividing by the sum of the Arithmetic Mean extensions for all index categories by the sum of the current year cost. This method was used by most taxpayers prior to the issuance of the new IPIC LIFO Regs. in 2002.
Appropriate Month - This refers to which month’s CPI or PPI indexes to use to calculate IPIC method Category Inflation Indexes. IRS Reg. § 1.472-8(e)(3)(iii)(B)(3) provides rules regarding selection of “Appropriate Months”.
New item - “New items” are inventory items that were purchased for the first time during the year and are on hand for the current year end. New items present a problem for internal index calculations because the inventory accounting system has no record of a prior year end unit price for the new item.
Involuntary LIFO termination - The termination of a taxpayer’s LIFO election by the IRS. The IRS Regs. allow the IRS to terminate a taxpayers LIFO election for the following reasons: 1) improper LIFO election, 2) violation of LIFO conformity Regs., 3) the current-year cost of inventories used for the LIFO calculation that are net of valuation reserves and 4) inadequate books and records maintained to adequately document the calculation of LIFO indexes and LIFO inventory balances.
UNICAP costs - This is the amount of labor and overhead that IRS Reg. § 263A requires taxpayers to capitalize as an add-on to inventory balances in addition to labor and overhead costs capitalized as required by GAAP. In other words, these are inventory related costs for which the IRS requires treatment as product cost rather than period cost. These costs are also referred to as Sec. 263A costs.
Retail Inventory Method (RIM) - Inventory accounting method historically used by many retailers whereby merchandise department cost balances are calculated by multiplying departmental cost complements (of gross profit margins) times departmental retail inventory balances because maintaining perpetual inventory records by item is not practical. Physical inventories for companies using the RIM method as the "retail cost" method on Form 3115 Schedule D, Part II, line 4a (page 6).
Retail LIFO - A term that describes the calculation of LIFO inventory balances by first converting retail inventory balances (the current-year cost) to retail basis inventory at base balances using inflation indexes that are a measure of retail price inflation. Layers at retail are then reduced to cost by multiplying them times the LIFO cost complements calculated for each pool.
Cost LIFO - A term that describes the calculation of LIFO inventory balances by first converting cost inventory balances (current-year cost) to inventory at base balances using inflation indexes that are a measure of inflation in the cost of inventory items.
IRS Form 970 - Application to Use LIFO Inventory Method. A Form 970 is required for:
IRS Form 3115 - Application for Change in Accounting Method -Taxpayers must file Form 3115 for LIFO-related methods changes including:
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