Bob Richardson

Dollar-value LIFO Background

The vast majority of companies on LIFO use what’s called the dollar-value method. Under this method, LIFO is essentially treated as an annual top-side adjustment to account for the change in the current vs. prior period’s LIFO reserve and to convert the year end inventory balance from cost to its LIFO value. Under the dollar-value method, the starting point of the LIFO calculation is determining the inventory value at cost. Once this has been determined, inflation must be calculated to convert inventory from its cost value to its base year cost & inflate the base year cost to its LIFO value. Once the current period’s LIFO inventory value has been calculated, the LIFO reserve is calculated by taking the difference between the cost & LIFO inventory value, and the top-side LIFO adjusting journal entry amount is determined by comparing the current vs. prior period’s LIFO reserve (aka LIFO expense when CY vs. PY LIFO reserve increases & LIFO income when it decreases).

Inflation Measurement Method Alternatives Background

Internal Indexes

Until the early 1980s, the only option to calculate inflation under the dollar-value method was to use a company’s actual quantities and costs of goods, which is commonly referred to as an internal index. Under this method, items are most commonly defined as the most detailed record-keeping unit maintained in the accounting system, which usually come in the form of an item/part/product number or code (aka SKU, UPC etc.). To calculate inflation using internal indexes, an inventory report is prepared containing each item’s current period quantity on hand and current and/or prior/base period unit costs (link-chain method uses prior period unit cost; double-extension method uses base period unit cost). Each item’s current period quantity on hand is double-extended against its current and/or prior/base period unit costs to determine the sum of the current and/or prior/base period extensions and for a current year or cumulative inflation index to be calculated (link-chain method requires current period inflation index to be calculated prior to determining current period’s cumulative inflation index; double-extension method directly calculates the current period’s cumulative inflation index).

External Indexes (aka IPIC method)

In the early 1980s, the IRS issued regulations permitting the use of external Consumer or Producer Price indexes published by the U.S Bureau of Labor Statistics to calculate LIFO inflation (BLS CPI/PPI). This is commonly referred to as the Inventory Price Index Computation or IPIC method.

Under the IPIC method, items are defined as the BLS CPI/PPIs applicable to the product mix, and unit costs play no part in the inflation calculation (only the current period’s extended costs by item is required when using the IPIC method). What instead occurs is that each item is assigned a BLS CPI/PPI, and the total inventory balance at cost or extended cost assigned to each BLS CPI/PPI is determined. A category inflation index is calculated by taking the quotient of each BLS CPI/PPI’s current & prior period index, and each BLS CPI/PPI’s prior period extensions are calculated by deflating each BLS CPI/PPI’s current period extended cost against its category inflation index (also known as harmonic mean weighted extension). The current year inflation index is calculated by taking the quotient of the sum of the current period’s extended costs & the sum of the harmonic mean weighted extensions.

Why do Companies Use the IPIC Method?

Maximize LIFO Tax Benefits

In many cases, the IPIC method will create more inflation than an internal index. Since the primary component in determining the size of the LIFO tax benefit, many companies choose to use the IPIC method. The primary reasons for the IPIC method creating more inflation than internal indexes are as follows:

  • New items are given the same inflation rate as preexisting items – Under the IPIC method, the same BLS inflation rate is applied to new & preexisting items because their price surveys are a weighted average of prices paid for all goods, and no adjustment or attempt is made to segregate new vs. preexisting items from the surveys received from producers & retail price surveys they collect. In contrast, under an internal index, new items are given a prior year unit cost that’s equal to the current period unit cost since the prior year unit cost is unavailable for any good that was not previously stocked (companies can reconstruct new item cost, but in practice, many companies set the new item prior year unit cost equal to the current year cost as it precludes the sometimes burdensome process of reconstructing a prior year unit cost for new items). Because of this, companies with a material amount of new items will often find that the external index inflation will be higher than an internal index simply because the zero inflation applied to all new items using an internal index materially reduces the weighted average inflation rate.
  • Prices paid for low-inflation import goods are included in the internal index calculation, but are excluded from the external index calculation – For many companies, a material amount of goods are acquired from abroad. In most cases, imported products inflation has historically been lower than exported goods. On the other hand, Bureau of Labor Statistics Consumer/Producer Price Indexes only measure price changes of domestically produced and sold goods. Because of this, internal indexes will often be lower than an external index.

 Simplification

The primary cause of the IRS issuing the IPIC method regulations was to lower the barrier to LIFO entry by precluding the need to perpetually maintain the records and perform the mathematical steps required when using an internal index. Said another way, in certain cases, the use of the IPIC method is less complex & more reliable than an internal index. This is especially true for manufacturers who must accurately integrate numerous cost components (material, labor & overhead) across multiple stages of production (raw materials, WIP & finished goods) to ensure an accurate measure of LIFO inflation. In other cases, the IPIC method is much simpler than an internal index thanks to the fact that inflation can be measured using a single or just a handful of BLS categories. For example, auto dealers using the alternative LIFO method often must take numerous steps to prior to performing the actual inflation calculation, which are as follows:

  • Obtaining purchase invoices for all vehicles on hand at year end
  • Extracting the following information from each invoice and hard-keying that data into an Excel file:
    • Stock number
    • Year
    • Make
    • Model code
    • Base vehicle costs
    • Net inventory method adjusting items (if applicable; includes adjusting items such as trade discounts & advertising expenses)
  • Preparing a summary of vehicles on hand by model code schedule
  • Calculating an average end of year base vehicle cost by model code schedule
  • Performing a lookup to the prior year end’s vehicles on hand to determine each model code’s prior year base vehicle cost
  • Using a price book to reconstruct the prior year base vehicle cost for any vehicle that’s on hand at year end that was not on hand in the prior year end (if applicable)

As seen above, there are numerous steps involved prior to calculating an internal inflation index for auto dealers. The IPIC method on the other hand only requires the following step:

  • Create a summarized schedule of year end inventory balance at cost by the following types (only need the totals be types listed below; detail of the cost by vehicle not required):
    • When using Producer Price Indexes (PPI):
      • Cars
      • Trucks
      • Parts (if included in the LIFO election scope)
    • When using Consumer Price Indexes (CPI):
      • New cars
      • New trucks
      • Used cars (if included in the LIFO election scope)
      • Used trucks (if included in the LIFO election scope)
      • Parts (if included in the LIFO election scope)

As seen above, the steps involved prior to calculating an inflation index is much simpler under the IPIC method than it is using an internal index for auto dealers.

IRS Safe Harbor Method

The IPIC method provides many advantages since it is an IRS safe harbor method, which are as follows:

  • When compared to an internal index, the IPIC method is more defensible & less prone to being challenged by the IRS in the event of an exam. This is because when applied directly, the Bureau of Labor Statistics is the source of the inflation calculation, and the IRS can not challenge the reasonableness of the inflation calculation as long as the correct BLS categories have been assigned, and the inflation has been correctly calculated. In contrast, when using an internal index, the taxpayer is the owner and source of the inflation calculation, so the responsibility is on the taxpayer to prove the reasonableness & accuracy of the inputs used to calculate inflation in the event of an IRS exam.
  • It affords companies already on LIFO audit protection from errors that occurred prior to making the switch to the IPIC method from a non-IPIC method. This is particularly attractive for companies who discover previous errors that caused a LIFO reserve overstatement (and tax underpayment) because the audit protection afforded to IPIC method taxpayers precludes the IRS from challenging any pre-change LIFO errors & imposing an unfavorable adjustment to income in the event of subsequent IRS exams.

 AICPA 1982 LIFO Issues Paper Regarding Usage of IPIC LIFO for Financial Reporting

Shortly after the IRS released the IPIC regulations, the AICPA’s Accounting Standards Division’s Executive Committee and its Task Force on LIFO Inventory Problems published an Issues Paper titled “The Acceptability of Simplified LIFO for Financial Reporting Purposes”.  The basic issue outlined in the Issues Paper was to, “…establish whether simplified LIFO [IPIC method] should be considered acceptable for financial reporting purposes”. The Advisory Conclusions were as follows:

  • Using the IPIC method for financial reporting should be considered acceptable unless it is apparent that the external index structure and its application do not reflect a company’s experience.
  • If an enterprise uses simplified LIFO [IPIC method] for tax purposes and another acceptable inventory method for financial reporting purposes that does not violate the LIFO conformity requirement, the effect of the difference should be accounted for as a timing difference under APB Opinion 11.

The key takeaways from this Issues Paper were as follows:

  • The use of the IPIC method will be considered GAAP as long as the external (IPIC method) & internal index inflation is comparable. For the remainder of this blog, we will refer to this as the “inflation comparability requirement”.
  • Companies using the IPIC method for tax & an internal index for financial reporting (book LIFO) should account for the difference between the book & tax LIFO values as a timing difference

In this author’s opinion, there were far more questions left unanswered by the Issues Paper than there were in the official positions and guidelines established, which were as follows:

  1. How is the external vs. internal index inflation to be determined comparable?

Since the calculation of the LIFO inventory value is primarily driven by the amount of inflation, one can assume the spirit of the AICPA’s conclusion was that they hoped for the internal vs. external index inflation to be compared and for a determination to be made regarding whether the results are comparable or not. But similarity and comparability is ambiguous, and there are numerous nuances involved with making such comparisons. Two examples are provided below to illustrate this problem.

Example 1: Let’s assume a company desired to switch to the IPIC method for the 2024 year end. Historically speaking, the company has historically had a 2% average annual inflation rate during the time it has used the LIFO method (this can be determined by dividing the current & base period cumulative indexes & raising it by one divided by the number of years the company has been on LIFO). To conform with the conclusions of the Issues Paper, it sought to establish that the company meets the AICPA’s inflation comparability requirement. In their attempt to do so, the company performed separate internal & external index LIFO calculations for the 2024 year end. The internal index inflation was 0.2%, and the external index inflation was 0.8%. When calculating the difference between the two results, the external index inflation was only 0.6% higher than the internal index, which is less than 1/3 of the company’s historical average annual inflation rate of 2% (0.6% ÷ 2% = 30%). But if one were to calculate the difference by taking the quotient of the external vs. internal index inflation, the result would be that the external index inflation of 0.8% was four times higher than the 0.2% internal index inflation (0.8% ÷ 0.2% = 4).

Example 2: Let’s assume a company considering a switch to the IPIC method has historically had a 3% average annual inflation rate during the time it had used the LIFO method. But following completing comparative internal & external index calculations, there was 1.5% internal index inflation & 3% external index inflation. In this example, the external index is twice as much as the internal index, but it’s in line with the company’s 3% historical average annual inflation rate. Furthermore, although the 1.5% inflation difference is 0.9% more than the difference in the first example, it’s only twice as much compared to the first example that resulted in the external index being four times higher than the internal index.

Based on a range of comparison metrics and inflation result outcomes, it’s obvious that completely different conclusions could be reached regarding whether or not the AICPA Issues Paper’s inflation comparability requirement was met.

  1. Does the inflation comparability requirement only need to be tested in the year of change, or should it include a historical comparison of the inflation measurement alternatives?

Since the historical inflation is the best indicator for establishing the preferability of LIFO, many companies perform pro forma historical LIFO calculations or make attempts to measure the inflation that has occurred in the past. Furthermore, since inflation is the biggest factor in determining the difference between inventory at cost & the LIFO value, the best way to measure the difference between alternative LIFO methods is to compare the inflation that has occurred in the past.

Since this is the case, it’s the author’s position that the historical inflation differential between an internal & external index should play more of a role in determining whether or not a company meets the AICPA’s inflation comparability criteria. With that being said, it has been our experience that auditors are much more concerned about the current period’s inflation differential between the IPIC method & an internal index when considering whether or not a company has met the AICPA’s inflation comparability requirement. It’s also the author’s position that this is misguided because over a long period of time, the long-term average cumulative index (which can used to derive the average annual inflation rate) will play a much bigger role in determining the difference between the internal & external index LIFO value.

To illustrate, let’s assume a company has a 2.5% internal index & 3% internal index historical average annual inflation rate at the time that a change from an internal to external index is being considered. In the period of the change, the internal index inflation was 1%, but the external index inflation was 4%. In some cases, auditors will ignore the fact that the internal vs. external index historical average annual inflation rate is only 0.5%, get hung up on the fact that the current year external index inflation was four times higher than the internal index, and object to a company changing to the IPIC  method on the premise that the company does not meet the AICPA’s inflation comparability requirement.

  1. Does the inflation comparability requirement need to be tested each period subsequent to the change from an internal to external index?

So you’ve jumped through the hoops to establish that your company has met the inflation comparability criteria, and you’ve now received a green light by your auditors to use or switch to the IPIC method. Most would figure that you can go along your merry way and put the use of an internal index in the rear view mirror, right? Unfortunately, some CPA firms have interpreted the AICPA’s inflation comparability requirement to imply that if the IPIC method will be used for financial reporting purposes, both an internal and external index calculation must be made annually in perpetuity to ensure the two methods are comparable until the end of time. Rather than hoping to make your LIFO approach simpler under the IPIC method, you’ve now realized that LIFO will actually be more complicated than before thanks to the AICPA’s inflation comparability requirement.

The AICPA Issue Paper was very vague regarding their inflation comparability requirement, and it’s a key shortcoming of what was likely designed to clarify and assist the accounting community on what some believe is a key LIFO issue. With that being said, the lack of clarity on how the inflation comparability requirements leaves room for the AICPA’s conclusion to be widely interpreted.

The issue with the vagueness becomes clear because no company would want to switch to a method that could all of the sudden be deemed unacceptable at any point in time. For example, let’s assume a company switched to the IPIC method, but two years later, it’s determined that the external & internal index inflation are materially different. That leaves the question of what happens if such an event occurs? Is the company required to switch back to an internal index when it’s discovered the external index inflation is materially different from the company’s “actual experience”? If so, this would discourage more companies from switching to the IPIC method, and for first-time LIFO elections, it may motivate companies from even electing the LIFO method if their only viable option for an adoption is to use the IPIC method.

  1. What is a company suppose to do if they switched to the IPIC method for financial reporting, but their auditor subsequently determines the inflation comparability requirement is no longer met in a future LIFO calculation?

The fly in the ointment here is two-fold. Firstly, for financial reporting, consistency is key, so performing frequent accounting method changes based on an Issues Paper that was never codified (meaning it never became authoritative guidance) would appear to be unreasonable on its face. Secondly, since the use of an internal index is not an IRS safe harbor method, advanced approval or consent from the IRS is required to switch to an internal index from the IPIC method. Knowing this, if a company were to switch to the IPIC method for tax purposes in addition to doing so for financial reporting (which nearly all do when electing or changing to the IPIC method), any subsequent change from the IPIC method back to an internal index for financial reporting would result in a company using separate book & tax LIFO methods. The unintended consequence from such a scenario is that a company is now forced to perform separate book and tax LIFO calculations in perpetuity unless they were to make a non-automatic consent tax accounting method change, and pay the roughly $12K IRS User’s fee required to file for the change.

  1. Should concepts such as materiality be considered when determining if the inflation comparability requirement should be applied to justify a change to the IPIC method?

In some cases, the LIFO reserve can become a material item on the balance sheet, and even create material differences on the income statement. In other cases, the LIFO reserve is immaterial in comparison to other financial report items, and when this is the case, the GAAP principle of materiality comes into play with changes in accounting methods and method alternatives in general. For example, lets assume a company’s internal vs. external index inflation was determined to be materially different, but the internal vs. external index year over year LIFO reserve change (LIFO expense when increase & income when decrease) was determined to be immaterial when compared to other financial report figures. Based on the AICPA Issues Paper, one could be led to believe that their true intent was to ensure that key financial report figures such as balance sheet accounts & income statement statements were not materially different when comparing an external & internal inflation measurement sources.

If this were the case, a company hoping to switch to the IPIC method could justify that the year over year change in the LIFO reserve is always an immaterial item on the financial report regardless of if internal or external indexes are used, and therefore the AICPA’s comparability requirement is not applicable regardless of the difference between the inflation or the resulting LIFO reserve change.

  1. When establishing its conclusion and position, did the AICPA take into account that the IRS established the IPIC method to make LIFO accessible to more companies, not less?

The IRS offering up the IPIC method as a simpler means of applying LIFO was a refreshing change that came from an organization that’s known for creating a perpetually more complex tax code. Unfortunately, the AICPA’s position on the acceptability of the IPIC method for financial reporting created obstacles for companies already on LIFO that are seeking to simplify their LIFO approach, and also caused companies who’re considering adopting LIFO to not elect after being told by their auditors that they can only use external indexes for tax purposes, and must use internal indexes for financial reporting purposes.

  1. When establishing its conclusion and position, did the AICPA take into account that in most cases, the IPIC method creates the most conservative financial reporting outcome?

In accounting, the conservatism principle (or accounting constraint) directs an accountant, who is faced with doubt between two possible alternatives, to choose the alternative that will result in less profit and/or the lowest asset amount. The conservatism guideline does not direct the accountant to be super conservative and beat down a company’s profits. The accountant is to be fair and objective. However, if that objectivity reveals two possible ways for recording a transaction, conservatism means recording the transaction or situation in a manner that results in less profit, less asset amount, and/or a greater liability amount. One of the fundamental accounting principles is conservatism. This general concept is to factor in the worst-case scenario of an entity’s financial future.

One GAAAP example of conservatism related to inventory is the requirement for companies who don’t use LIFO to value inventories at the lower of cost or its net realizable value, and for companies who do use LIFO to value inventories at the lower of cost or market. The effect of this principle is that amongst the alternative approaches, the lowest inventory value is recognized on the balance sheet and the highest cost of goods sold & lowest profit is recognized on the income statement.

Since the IPIC method usually creates more inflation than an internal index, its use will typically result in a lower LIFO inventory value, higher cost of goods sold & less income being recognized than an internal index. Because of this, when the IPIC method is used for financial reporting purposes, it can be expected for the IPIC method to create the most conservative inventory value, highest cost of goods sold and lowest income.

If conservatism is truly an important accounting principle, one must ask why the AICPA panel sought to place conditions and limitations from utilizing the IPIC method since it most often yields more conservative financial reporting results than an internal index.

Is the AICPA Issues Paper Authoritative Guidance?

AICPA Issues Papers Issues Papers were originally intended to be an evenhanded discussion of topics that needed to be “addressed or clarified by the Financial Accounting Standards Board.” Issues Papers were the vehicle the AICPA’s Accounting Standards Executive Committee (AcSEC) used to present emerging practice problems to the FASB and accounting practitioners.

Although many accounting firms use the AICPA LIFO Issues Paper to take positions and form opinions on topics such as the use of the IPIC method for financial reporting, the Issues Papers were not and will never be enforceable standards. Furthermore, they are not considered authoritative guidance because the conclusions reached by the LIFO inventory task force were never codified as Accounting Standards Codification by the Financial Accounting Standards Board (FASB). If the AICPA or FASB wanted the recommendations reached in the LIFO Issues Papers to become authoritative guidance, they would have done so by including those recommendations within the Accounting Standard Codification or ASCs that became the single source of financial reporting authoritative guidance in 2009.

Although FASB never codified the LIFO Issues Paper or made it GAAP authoritative guidance for GAAP, the  Securities and Exchange Commission (SEC) essentially dide. Within the SEC’s codification of Staff Accounting Bulletins, the SEC’s interpretative response regarding the LIFO Issues Paper was as follows (see SEC Staff Accounting Bulletin No. 5L: LIFO Inventory Practices):

In the absence of existing authoritative literature on LIFO accounting, the staff believes that registrants and their independent accountants should look to the paper for guidance in determining what constitutes acceptable LIFO accounting practice.7 In this connection, the staff considers the paper to be an accumulation of existing acceptable LIFO accounting practices which does not establish any new standards and does not diverge from GAAP.

The staff also believes that the advisory conclusions recommended in the issues paper are generally consistent with conclusions previously expressed by the Commission, such as:

  1. Pooling-paragraph 4-6 of the paper discusses LIFO inventory pooling and concludes “establishing separate pools with the principal objective of facilitating inventory liquidations is unacceptable.” In Accounting and Auditing Enforcement Release 35, August 13, 1984, the Commission stated that it believes that the Company improperly realigned its LIFO pools in such a way as to maximize the likelihood and magnitude of LIFO liquidations and thus, overstated net income.
  2. New Items-paragraph 4-27 of the paper discusses determination of the cost of new items and concludes “if the double extension or an index technique is used, the objective of LIFO is achieved by reconstructing the base year cost of new items added to existing pools.” In ASR 293, the Commission stated that when the effects of inflation on the cost of new products are measured by making a comparison with current cost as the base-year cost, rather than a reconstructed base-year cost, income is improperly increased.

Although the SEC bulletin did not go as far to specifically reference the AICPA’s IPIC for financial reporting conclusion, the overall position taken leads most to assume that the inflation comparability requirement must be met for SEC registrants to be eligible to use the IPIC method.

Treatment of IPIC LIFO for Financial Reporting in Practice

The IPIC method is an IRS safe harbor method, and the IRS provides no limitations that prohibits the use of the IPIC method for financial reporting as it’s essentially the tax authority’s preferred inflation measurement source (internal indexes is not a safe harbor method). So the use of the IPIC method for financial reporting ultimately boils down to whether or not audited or reviewed GAAP financial reports are issued. So in practice, companies who do not issue audited or reviewed GAAP financial reports essentially have a green light to use the IPIC method for both financial reporting and tax purposes. The practice regarding using the IPIC method for financial reporting and tax is more nuanced for companies who issue audited or reviewed GAAP financial reports as they are essentially beholden to the opinion or position of their auditors.

The Big Four CPA firms and a select few of top 20 CPA firms essentially treat the AICPA LIFO Issues Paper’s inflation comparability requirement as authoritative guidance. For companies whose auditors are the handful of firms who take such a position, those who issue GAAP financial reports who’re seeking to use or change to the IPIC method for book & tax are often required by their auditors to compare the difference between the two methods. When this is the case, since the company is obviously preferential towards using the IPIC method, the ability to do so rests with the auditors who’ll ultimately opine regarding whether or not the AICPA Issues Paper’s inflation comparability requirement has been met. If one were to assume that the IPIC method & internal indexes are deemed to be comparable, certain auditors will take a position that a prerequisite of using or switching to the IPIC method for financial reporting is for the client to annually prepare parallel internal index & IPIC calculations, compare those results & determine if the AICPA Issues Paper’s inflation comparability requirement has been met.

Companies who issue GAAP financial reports whose auditors are not one of the select few CPA firms are largely allowed to use the IPIC method for financial reporting and tax without consideration of the Issues Paper’s inflation comparability requirement as they view the IPIC method as an acceptable method for financial reporting purposes.

Over 9 out of 10 LIFOPro clients use the IPIC method. Because the IPIC method often creates meaningfully higher LIFO tax benefits than an internal index, most companies prefer to use the IPIC method. Many companies choose to use the IPIC method because in addition to it creating more tax benefits than an internal index, it’s also simpler than using an internal index. One example of this is auto dealers since the IPIC method precludes the need to extract information from each vehicle purchase invoice to calculate inflation using internal indexes.

Generally speaking, outside of auto dealers & certain other situations, there’s usually a slightly higher outsourcing cost associated with the IPIC method compared to internal indexes since BLS categories must be assigned when using the IPIC method. But in most cases, the additional LIFO tax benefits achieved by using the IPIC method over an internal index far outweigh the extra outsourcing cost required to assign BLS categories.

Key Takeaways

In seeking the most beneficial LIFO tax outcomes for our clients that also comply with IRS Regs., LIFOPro advises our clients to use the IPIC method for book & tax purposes even if they’re faced with objections by their auditors in doing so. Our reason for doing so is follows:

  • Unless you are an SEC registrant, the AICPA Issues Paper is not authoritative guidance. Accordingly, the tax LIFO regulations serve as financial reporting authoritative guidance in the absence of GAAP LIFO codification.
  • Since the IPIC method is an IRS safe harbor method, it’s also an acceptable method for financial reporting since there are no formal financial reporting LIFO authoritative guidance (for companies other than SEC registrants)
  • Although the Issues Paper is a best practice guide, LIFOPro’s experience is the vast majority of companies who use the IPIC method do so for financial reporting and tax, and only publicly traded companies who’re bound by the SEC’s position on the LIFO Issues Papers use the IPIC method for tax purposes and an internal index for financial reporting purposes
  • LIFOPro’s mission statement is to make LIFO as simple as possible, & we strive to maximize our clients LIFO tax benefits while doing so at the lowest outsourcing costs. As a part of this mission, we advocate for our clients to use the IPIC method for book & tax rather than having to pay additional outsourcing costs for performing separate book & tax LIFO calculations.

Contact LIFOPro today to get a complimentary pro forma IPIC method calculation or learn more about the use of the IPIC method for financial reporting, or learn more about the IPIC method here: IPIC LIFO Advantages