Lee Richardson

The IRS Regs. allow two LIFO inflation measurement sources. LIFO taxpayers can either use:

  1. External indexes – The IRS Regs. were amended in 1982 to permit the use of the Inventory Price Index Computation (IPIC) method for which Producer Price Indexes (PPI) or Consumer Price Indexes (CPI) are used.
  2. Internal indexes – This is a comparison of the current & prior or base year prices for all items.

The primary challenge when using the internal index method is determining the inflation for new items. Since new items are present in the current period but not in the prior period, their costs are unknown. When using internal index LIFO, the following three options are available for determining inflation for new items:

  1. Only preexisting items are included in the inflation computation and new items are excluded altogether. The shortcoming behind this method is that both the 1984 AICPA LIFO Issues Paper & IRS Regs. prohibit such an approach being employed.
  2. The prior year end item cost is “reconstructed” which means research is performed using any reasonable means to determine what the prior year end cost would have been if the item had been included in inventory. For companies with diverse product mixes, reconstruction will likely prove to be both time consuming and heavy reliant on estimates. The burden of reconstructing costs annually may be reduced by employing some type of systematic method that involves using the historical costs of similar items, but the shortcoming of this method is that it relies largely on estimates, meaning it’s a less accurate measure of inflation than a method that avoids using estimates altogether.
  3. The item cost for the prior year end is set equal to the current year end item cost. The virtue of this method is simplicity however since this results in zero inflation for new items, the pool index will be less (when there is inflation) than when using the other two methods. To further illustrate, lets assume that 70% of the ending inventory balance is composed of preexisting items while the remaining 30% represents new items. If inflation for the preexisting items is 3%, the current year inflation rate will be reduced to roughly 2% due to the new items having zero inflation. These facts are further illustrated below:
Item Type Current Year Quantities at Current Year Costs Current Year Quantities at Prior Year Costs Inflation Rate
Preexisting Items $700,000 $679,612 3.0%
New Items  300,000  300,000 0.0%
Combined Totals $1,000,000 $979,612 2.1%

Only the second two methods described above are allowable for both IRS rules (IRS Reg. § 1.472–8(e)(2)(iii)) and GAAP LIFO guidance (1984 AICPA LIFO Issues Paper).

In our experience, the overwhelming majority use method #3 described above where all new item’s prior & current year costs are set equal to one another. Although previously mentioned as impermissible, excluding new items has been the next most commonly employed method that we have seen in practice. Although one may assume that the “reconstruction” method may be more commonly employed thanks to the potential additional LIFO benefits it offers, we have seen this method used the least. For the LIFO calculations we have reviewed using reconstructed costs, the methods being employed often appeared to be unsystematic and sometimes controversial. In one particular case, a company was taking two years worth of inflation to reconstruct new item cost. Although this went unnoticed for quite some time, a certain period’s LIFO calculation created nearly 14% inflation that resulted in a $6 million increase to their LIFO reserve. This event caused alarm within the company, and their CPA eventually brought the matter to our attention. After making a pro forma internal index calculation it was determined that the internal index inflation would have been only 2% if new items were treated as having equal current & prior period costs. At the same time, we also made a parallel external index inflation calculation that created nearly 6% of inflation. This example highlights the pitfalls of both reconstruction and setting new items current & prior year costs equal to one another.

Because we have helped numerous companies change to the IPIC method, we have made numerous comparisons of internal vs. external index inflation. When making these comparisons, the majority of them have resulted in the external index inflation being higher than internal index. We believe that this is due to most of the comparisons that we’ve made assume that new items prior & current year costs equal one another for internal indexes whereas external indexes do not. This is because external index inflation is computed using the same inflation indexes for both preexisting & new items. This means that the new item zero inflation dilution issue that occurs when employing internal indexes is avoided altogether when using external indexes.