FAQ’s

FAQ’s

We are fed up with using spreadsheets for LIFO calculations but we cannot decide whether outsourcing our LIFO calculations to your firm or using the LIFO-PRO software is better for us.

The more frequently you make LIFO calculations, the more likely you would want to use the software. For example, if you make midyear calculations quarterly for financial reporting or for tax provision or quarterly payments estimates, you may be a good candidate to use the LIFO-PRO software. Corporations that have separate LIFO pools for a number of different legal entities are more likely to want to use the software.

What type of company should adopt LIFO?

Companies that possess these attributes are good candidates to use the LIFO method:

• Profitability or the expectation of future profitability and the desire to reduce taxable income
• Consistent inflation
• Significant inventories

Significant LIFO reserves can be generated without having huge amounts of inventory if there is more than a nominal amount of annual inflation. A reliable predictor of the amount of annual income tax deferral from use of LIFO is beginning of year FIFO inventory balance times the current year inflation rate. As an example, a company with $2 million in FIFO inventory and 2% annual inflation would increase their year-end LIFO reserve by approximately $40,000 per year.

What type of company should not adopt LIFO?

Companies with consistent deflation should not use LIFO. We believe the companies with very volatile prices for significant portions of their inventory are not good LIFO candidates. High inflation during the year can cause a big increase the LIFO reserve but big decreases in inflation are likely in subsequent years and using LIFO can be real roller coaster. Companies with commodities inventories should only adopt LIFO if they are prepared to terminate their LIFO election if there is enough deflation such years to create negative LIFO reserves (LIFO inventory greater than FIFO inventory). If a company wants to terminate their LIFO election before they have used the LIFO method for five years, this is an advance approval tax accounting method change for which the IRS user’s fee is about $9,000. The IRS rules allow companies to use the LIFO inventory method selectively, that is for some inventories but not others. For example, many convenience store chains that have gasoline inventories do not use the LIFO method for gasoline but use LIFO for merchandise sold in their stores (cigarettes, food and beverages, etc.) which has a good history of inflation over the years.

What are the pros and cons of the specific goods LIFO method (“unit LIFO”)?

This was the only LIFO method allowed by the IRS until 1947 but this method should never be used because of the burdensome record keeping requirements and the fact that the taxable income deferral using this method is only a fraction of the deferral achieved using a dollar-value LIFO method. This is a link to our blog article addressing this question:

Beware of Specific Goods LIFO Calculations

What are the pros and cons of using the double-extension LIFO method?

The double-extension LIFO method should never be used. We recently wrote a 27 page article describing in detail why this method is completely unreliable for purposes of measuring LIFO inflation and why this method should not be considered a permissible method by either the IRS or GAAP. This is a link to Lee Richardson’s article addressing this question:

Why double extension is a bad LIFO Method

What are the pros and cons of the using the IPIC LIFO method?

Advantages of using the IPIC LIFO method include:

• Good possibility of greater inflation than internal index method
• Manufacturers LIFO inflation should be less volatile than if an internal index method is used
• IPIC is a simpler method and less prone to index calculation errors
• A change to the IPIC method provides audit protection which is very important for a substantial number of LIFO taxpayers using bad methods
• A change to the IPIC method is the only way in which a taxpayer using the double-extension method can make a change to the link-chain method as an automatic approval change
• Fewer LIFO pools are possible

A disadvantage of using the IPIC method is that once the method is used, it is not an automatic approval change to switch back to an internal index method if an internal index method had been used before the company change to IPIC method. What can be a disadvantage for some manufacturers is the fact that the different index categories published for their products is not granular enough. For example, we have had client that had to use a nonferrous metals PPI code because there is no indexes published for their specific metal for that particular stage of production.

Can a LIFO method be used for tax purposes that is different than the LIFO method used for financial reporting?

Yes, the “LIFO conformity rule” which is contained in Reg. § 1.472–2(e) were amended in 1981 to specifically permit the use of book LIFO methods that are different from IRS Regs. methods. The most common book v. tax LIFO methods difference is companies using the IPIC method for tax purposes and an internal index method for financial reporting purposes.

Will inflation be higher using IPIC LIFO compared to internal indexes?

Over time, for retailers and wholesalers, the IPIC method PPI inflation is usually higher than internal index inflation. For some companies, the actual price comparison may be very close to being the same between the two methods but there is an internal index inflation dilution factor that results from setting the prior year item cost equal to the current year cost for new items (the method used by most companies using an internal index method).

For manufacturing companies, there can be a substantial difference annual inflation between internal indexes and PPI indexes. Below is a link to a blog article which describes the reason for this and why using the IPIC method usually results in much less volatile LIFO inflation than for manufacturers using an internal index method:
Why internal index LIFO inflation is often more volatile than PPI inflation for manufacturers

Are CPI or PPI indexes better for maximizing tax LIFO benefits?

While there may be a few items for which CPI inflation has consistently been higher than PPI inflation, for most retailers, there is a long history of there being greater (and sometimes significantly greater) PPI inflation than CPI inflation. For example, for the dozen or so years ended in 2014, PPI inflation for supermarkets outperformed CPI inflation during that period.

Your clients appear to be the who’s who of the Fortune 500. Do you provide services or software to smaller companies and are these services affordable?

We serve numerous companies with less than $10 million in inventory value. Our extensive experience enables us to be as efficient as possible and charge the lowest possible fees.

We can outsource our LIFO calculations to other service providers. Is your firm the only company that provides a LIFO software licensing option?

There are two vendors that sell auto dealer LIFO calculation software. Other LIFO service providers have attempted to develop non-auto dealer LIFO calculation software in the past but they were not successful. Some companies may want to outsource their LIFO calculations but many corporations want to use software to make their LIFO calculations in-house. LIFO-PRO has over 30 clients that were once clients of another LIFO service provider that now use our services. LIFO-PRO’s clientele do not switch from using our services to that of a multinational company.

A CPA firm told us that they have software that makes non-auto dealer LIFO calculations. Your company’s web site says that your LIFO-PRO program is the only such software.

LIFO-PRO is the only non-auto dealer LIFO calculation software with a menu-driven user interface. There are a number of LIFO calculation Excel templates in use but it is a real stretch to call this software because:

• PPI and CPI index lookups are not automated and 10% method calculations are manual; these cannot be automated in a spreadsheet
• Updating of LIFO layer histories is not automated and a complete set of reports are not automatically generated
• Report printing is not automated

What services do you provide to CPA firms?

The most common service we provide to CPA firms is what we call our Service Bureau for which we are provided a LIFO layer history in the first year in an Excel file listing the year and inventory balances by PPI or CPI category in the first year and succeeding years.

Other services we provide CPA firms include:

• Preparation of forms 970 and 3115
• Pro forma IPIC method LIFO calculations and other LIFO pre-adoption analysis
• LIFO best practices review
• Assignment of proper PPI and CPI codes to inventory items
• We have several CPA firm clients who have purchased a license to use our software and they use it to make LIFO calculations for a number of their clients

Common LIFO Misconceptions

• LIFO benefits will be minimal for companies with frequent inventory turnover – Inventory turnover rate is irrelevant; only the FIFO inventory balance (current-year cost) and inflation (deflation) rate impact the amount of LIFO expense.
• Low inflation rates will not produce significant LIFO benefits – Consistent positive inflation can produce sizable LIFO benefits for companies with significant inventories. Sizable LIFO benefits are also possible for companies with small inventories for which there is consistently high inflation.
• Book and Tax LIFO methods need to be consistent – This was true until the late 1970s but the IRS Regs. LIFO “conformity rule” was changed at that time to require only the conformity of the LIFO election scope (goods on LIFO). The Regs. specifically permit different book and tax LIFO methods.
• Valuation (Lower-of-Cost-or-Market) reserves provide as much or more benefit than LIFO – If this seems to be true for a company, the reserving method would not likely pass muster with the IRS. Even if a LCM reserve may exceed the first year LIFO reserve, the LIFO reserve will grow with continued inflation regardless of FIFO value increases and this is not true of LCM reserves. LCM reserves must be taken into income when LIFO is adopted as a Section 481(a) adjustment but this is spread over 3 years.
• LIFO reserve increases require increasing ending inventory balances – Unless inventory balances decrease significantly, the amount of inflation is a far more important determinant of LIFO expense than inventory balances and significant LIFO reserve increases are possible even with sizable inventory decreases.

Examples Showing That the LIFO Reserve Can Increase as the Current-Year Cost Decreases

Example 1: Assumption – Current-year cost increases at the same rate as inflation starting at $1,000,000 in the base year | Result – 2002 – 2005 LIFO reserve increases by $20K – $21K per year

Example 2: Assumption – 2005 & 2004 CYC are equal (2005 CYC = $20K less than Example 1) | Result – 2005 LIFO reserve increases by just under $20K

Example 3: Assumption – CYC is the same for all years | Result – 2002 – 2005 LIFO reserve increases by $18K – $20K per year ($76K total)

Example 4: Assumption – 2004 & 2005 CYC are $50 & $100K less than Example 1 | Result – 2004 & 2005 LIFO reserve increases by $18K & $16K

Example 5: Assumption – CYC decreases by $50K/year ($200K total) | Result – 2002 – 2005 LIFO reserve increases by $12K – $19K per year ($61K total)

Common LIFO Calculation Errors

Manual spreadsheet LIFO calculation formula errors

=IF(F46>0,F46*D46,IF(-F46<C57,F46<C57,F46*D57,IF(F46<C58,F57+((F46+C57*D58),IF(-F46<C59,F58+((F46+C58)*D59, IF (F46<C60, F59+((F46+C59)*D60),IF(F46<C61,F60+((F46+C60)*D61),IF(-F46<C62,F61+((F46+C61)*D62),IF(-F46<C63,F62+((F46+C62)*(D63),IF(F46 <IF(F46<C64,F63+((F46+C63)*D64),IF(-F46<C65,F64+((F46+C64)*D65),IF(-F46<C66,F65+ ((F46+C65+ ((F46+C65)*D66),IF(F46<C67+ ((F46+C66)*D67),IF(F46<C68,F67+((F46+C67)*D68),IF(-F46<C69,F68+(( F46+C68)*D69),IF(-F46<C70,F69+((F46+C69)*D70),ERR)))))

This is an example spreadsheet formula that calculates LIFO inventory balances & all possible layer liquidation possibilities for a company with 15 LIFO layers. These types of formulas are convoluted & require updating when used in subsequent years/pools. The high probability for errors to occur causes manual spreadsheet LIFO calculations to be unreliable.

General LIFO Calculation Errors

• Incorrect decrement calculations – These are very common in spreadsheet LIFO schedules
• Incorrect calculation of Sec. 263A costs – For taxpayers for which these are an add-on costs to the calculation of Sec. 471 LIFO balances, errors are common for years in which there are decrements
• LIFO reserve balances don’t tie to detail – The current and prior year inventory at base and LIFO inventory balances should tie to the LIFO layer history carryforward schedule

Internal Index Calculation Errors

• Exclusion of new items in inventory – IRS LIFO Regs. specifically prohibit exclusion of items not in inventory the prior year(link-chain) or base year(double-extension) because doing so tends to overstate inflation. The Regs. allows the prior year or base year index to be set equal to the current year price, but this method understates inflation.
• Using current year prices for prior periods – The easiest way to handle new items is to set the prior period item price equal to the current year item price. This method is allowable by the IRS but this method will understate LIFO inflation and the understatement can be significant especially for double-extension method taxpayers.
• Improper representative sampling – The potential for errors of this nature are great and the likelihood of this type of error increases for taxpayers that have a diversity of inventory types and locations.

IPIC Method Pool Index Calculation Errors

• Wrong indexes or BLS weights looked up – The typical supermarket chain’s IPIC calculation, when performed correctly, will make use of approximately 60 (30 current year & 30 prior year) CPI indexes and 20 BLS Weights. This is a total of 80 numbers to be looked up, and there is almost always at least one error when these indexes are looked up manually.
• Changes in makeup of CPI or PPI categories – There are frequent changes to the PPI Table 6 categories with numerous new categories added and deleted every year. Many taxpayers use the same categories year after year without determining whether indexes are still compiled for the categories used or whether they have inventories in categories added since the prior year end.
• Inconsistent use of PPI Preliminary or Final Indexes – The IRS Regs. allow use of either preliminary or final PPI Table 6 indexes, however taxpayers are to consistently use either preliminary or final indexes. Most taxpayers use preliminary indexes, but accessing preliminary indexes on the Web is tricky since only final indexes are included in the BLS database available on the Web starting the fifth month after indexes are published.
• Wrong indexes or BLS weights categories used – An example of this error is the use of the SAF116 Alcoholic beverages CPI category. This category includes SEFX Alcoholic beverages away from home as well as SEFW Alcoholic beverages at home . SEFX is not a commodity-only price index and should not be used. SEFW is the appropriate category to use in the LIFO calculation.
• Incorrect 10% method rollups – Spreadsheets cannot handle the logic necessary to deal with situations where category indexes are to be calculated based on the 10% threshold being met when this level changes in subsequent years because of inventory mix changes. As a result, category indexes are often calculated at the wrong level.
• Incomplete accounting of items actually present in inventory – A good example of this error is often seen for supermarket chains in their APPAREL commodities inventory. Because the APPAREL dollars are substantially less than 10% of total inventory, only the total APPAREL commodity dollars need be gathered. Most large supermarket chains carry only a few of the APPAREL commodity categories in inventory, so only the CPI indexes and BLS weights for those categories should be used for the APPAREL commodities index category index calculation. The shortcut commonly used, in error, is to use the overall APPAREL commodities index rather than the correct weighted average using the indexes and BLS Weights for the categories actually present in inventory.
• Weighted average indexes – Various spreadsheet formula errors are common for both category indexes(using BLS Weights for the 10% method) and for the dollars weighted average pool index calculations.

Potential LIFO Errors & Preventative Controls