If it (IPIC LIFO method) is good enough for the IRS, it should be good enough for GAAP

If it (IPIC LIFO method) is good enough for the IRS, it should be good enough for GAAP

If it (IPIC LIFO method) is good enough for the IRS, it should be good enough for GAAP

The majority of companies using the IPIC (Inventory Price Index Computation, a.k.a. “Simplified LIFO”) method for tax purposes also use this method for their financial statements. Most of the other companies using LIFO would also prefer to use the IPIC method for both tax and financial statement purposes but are prevented from doing so because their auditors tell them that the use of the IPIC method is not acceptable for GAAP.

The reason some auditors consider that the IPIC method is not acceptable for GAAP is based on the Issues Paper published by the Accounting Standards Division of the AICPA and dated October 14, 1982 entitled The Acceptability of Simplified LIFO for Financial Reporting Purposes. The last paragraph of this paper (paragraph 16) reads:

“The Accounting Standards Executive Committee and its Task Force on LIFO inventory problems believe:

Simplified LIFO using 100% of the external index should be considered acceptable for financial reporting purposes unless it is apparent that the external index structure and its application do not reflect a company’s experience.”

7 of 10 AcSEC members agreed with this statement. 6 of 8 Task Force members agreed with this statement.

With the advantage of hindsight, a shortcoming of this Issues Paper is that it does not provide any guidance about what “…unless it is apparent that the external index structure and its application do not reflect a company’s experience” means in application. Does the pro forma internal index inflation need to be within 1% of the IPIC inflation or is the acceptable difference more or less than this? Is the inflation difference between the two methods to be compared on an annual basis or over a number of years and if so, how many years?

Because no guidance was provided to address this question, the CPAs that consider this Issues Paper to be definitive GAAP guidance generally think that this inflation comparison needs to be made every year. This interpretation effectively means that even though a company wants to use IPIC for GAAP and ends up using IPIC for GAAP, they are forced to make an internal index calculation every year in addition to the IPIC method calculation to be able to make this comparison. One could argue that a full internal index calculation is unnecessary and that an estimate of internal inflation would suffice but anyone with substantial LIFO experience would tell you that unless the internal index estimation calculation was made by someone with at least hundreds of hours of LIFO experience (these people are few and far between), such an estimate would most likely not be reliable.

From a purely theoretical perspective and notwithstanding the fact that this major question was ignored, the Issues Paper guidance makes sense. How can one seriously argue that the use of nationwide government price indexes for the various types of items included in inventory is a preferrable LIFO inflation measurement method to the measurement of a company’s LIFO inflation using the company’s inventory records.

What the Issues Paper failed to address was the qualitative aspect of an internal index calculation. In actual practice, the steps required to make an accurate and reliable internal index calculation are often much more complicated than an IPIC method LIFO calculation and substantial LIFO experience is required in these cases to reliably measure internal index inflation.

Our firm has substantial internal index calculation experience, and I spent over 1,000 hours developing an internal index calculation module that is now part of our LIFOPro software. Internal index calculations are straightforward and not terribly complicated for some companies. For a retailer (assuming they do not use the Retail Inventory Method) or wholesaler with a single or a small number of locations, if the inventory detail records are well organized, what we would consider to be accurate and reliable LIFO index calculations can be made without much effort (especially if an internal index calculation program is used and not just an Excel template). However, there are many companies for which the internal index calculation is much more complicated and prone to error and some of these situations are described below.

These are some of the challenges in making accurate and reliable internal index calculations in a timely manner:

1. New items – These are defined as items for which the current year end quantity on hand is greater than zero but for which none of these items were on hand the previous year. IRS and other GAAP guidance (Issues Paper published by the Accounting Standards Division of the AICPA and dated November 20, 1984 entitled Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories) for these items is that estimates can be made of what the prior year item cost would have been and the term used for this is “reconstruction” of the prior year end item cost. It is not permissible as per the IRS Regs. or for GAAP to ignore the new items and measure inflation only using non new items. What is permissible as per the IRS Regs. and for GAAP is to set the prior year end item cost equal to the current year end item cost for new items which means there is zero inflation for all new items. A company would want to shy away from using this method for tax purposes because this understates LIFO inflation, but this is the method most companies use for GAAP because this understates LIFO inflation. What this means for a company for which the inventory item turnover rate is 20% a year (20% of all items each year are new items) is that their LIFO inflation is automatically either understated or overstated by 20%.
2. Purchase price variances (PPV) for manufacturers using standard costs – For these companies, internal indexes are calculated by comparison of the current year standard cost per item to the prior year end standard cost. An accurate measurement of inflation for this type of situation should entail consideration of the portion of the PPV that is applicable to the ending inventory (referred to as the capitalized PPV). When there is substantial inflation or deflation during a year, exclusion of the PPV component can significantly overstate or understate the proper amount of inflation. We have seen multiple situations for which this has happened. The PPV for the prior year needs to also be considered however it is not appropriate to use the dollar amount of the prior year capitalized PPV dollars as an item in the prior year extended cost column because the prior year end PPV dollars are applicable to the prior year end inventory mix and not the current year. If those making this calculation do not know how to properly deal with this mathematically, this can cause a misstatement of the actual inflation or worse yet, the PPV may not be considered at all.
3. Consideration of trade discounts – These discounts often represent significant amounts and if they are not properly considered, the inflation could be misstated. The adjustment for these discounts needs to be calculated as a “top side adjustment” because such discounts are usually not a reduction of the item cost value in the inventory accounting system.
4. The use of sampling methods – Many companies with numerous locations use sampling methods to reduce the amount of work required but the result is an estimate of a company’s inflation using only a portion of their inventory and the quality of the results will correlate to the amount of experience for those making the sampling method decisions.
5. Treatment of outliers – Accurate internal index calculations require analysis of inflation and deflation outliers (inflation or deflation above a certain threshold, e.g. 30% for an individual item). Outliers may result from a change in the unit of measure from one year to the next but also because of inaccuracies in item cost values. Substantial time may be required in order to determine which outliers are to be excluded from the index calculation. Some companies do not review outliers and some simply exclude all outliers that exceed a certain threshold.
6. Retailers using RIM – The use of an internal index calculation method for retailers using the retail inventory method (RIM) is problematic because perpetual inventory records are not maintained. An internal index calculation for a company using RIM would entail an estimation process on a sampling basis. We have seen situations for this type of company for which the internal index inflation was calculated using only the warehouse inventories and store inventories are completely excluded from the calculations.

It is not uncommon for companies to use internal index calculation methods that are impermissible methods in the eyes of the IRS. These methods are considered impermissible by the IRS because these methods are not reliable methods to use for LIFO inflation measurement. The most common of these methods include:

1. Improper item definition – Many companies use what we refer to as equivalent items or units. Instead of using actual inventory items, pounds or some other unit of measure is used. It is not uncommon for a company selling metal products to use the average cost per pound to compare LIFO inflation from year to year. They build a LIFO layer history schedule using pounds instead of dollars as the inventory at base prices value. This is an impermissible method even if multiple pools are used for different types of metals because this is an estimate of LIFO inflation the IRS considers not to be reliable because inventory items are defined too broadly to accurately measure inflation.
2. Not measuring inflation for overhead and labor for manufacturers – Manufacturers not using a standard cost system (for which labor and overhead costs are included in the item cost) will often measure LIFO inflation using only the raw material component of the item cost values and the labor and overhead components of item cost are ignored. This is not permissible to the IRS because this assumes that the labor and overhead inflation is the same as the raw material costs. In past years, this caused many manufacturers to exclude labor and overhead costs from their LIFO election scope. Many of these companies expanded their LIFO election scope to include labor and overhead when they switched to the IPIC method for tax purposes (because PPI and CPI indexes measure the total cost or price) but for financial statement purposes use the raw materials inflation for labor and overhead also.
3. Use of manufacturers price books for equipment retailers – Companies in this business use specific identification as the current-year cost method and do not use SKUs as most companies would making the use of a normal internal index calculation method impossible. Some of these companies use a comparison of costs for common equipment models between years by reference to a manufacturer’s price books. This LIFO inflation estimation method is not permissible to the IRS and the use of the IPIC method is the only practical method for such companies.
4. Use of the double-extension method – At present, the use of this method for which prices are compared from the current year back to the base year instead of to the prior year is permissible to the IRS. We believe that the IRS will no longer consider this a permissible method at some point in the future because this method does not measure inflation. This method measures inflation as adjusted for the change in inventory mix from one year to the next, which means that this is an unreliable estimate of inflation, and this fact is well known to those with substantial LIFO experience. The use of this method is also not practical because using this method requires companies to determine what the unit cost for an item would have been 50 years ago or for however long LIFO has been used.

Companies use the methods described above for financial statement purposes even though these methods are impermissible to the IRS because there is no LIFO GAAP guidance that specifically prohibits the use of these methods. There was no need for GAAP guidance about this prior to 1980. Before 1980 when the IRS “conformity rule” portion of the IRS Regs. required companies to use the same LIFO method for financial statements as is used for tax purposes. The conformity rule was changed in 1980 to allow companies to use a different LIFO method for financial statements than is used for tax purposes.

All of the problems with the use of internal index calculation methods described above are solved by the use of the IPIC method. The use of the IPIC method does not require substantial LIFO experience. The most important aspect of the ability to make a reliable measurement of LIFO inflation when using this method is the assignment of appropriate PPI or CPI commodity codes to inventory items. The requirement to possess substantial experience to properly deal with the laundry list of ways in which an internal index calculation can become unreliable is not necessary when the IPIC method is used.

The IRS wrote regulations to establish the use of the IPIC method in 1984. The reason the IPIC Regs. were written was to provide a less complicated and error prone LIFO method for taxpayers and CPAs to use. The IRS was aware of the many ways in which internal indexes can become unreliable. Not only did the IRS permit the use of the IPIC method starting in 1984, BUT the IRS also considers the IPIC method to be a better LIFO calculation method than using internal indexes. Evidence supporting this includes:

1. A change to the IPIC method is an automatic approval method change requiring no advance consent.
2. IRS audit protection is provided to a taxpayer when a change to the IPIC method is made. This audit protection means that once a change to the IPIC method is made, the IRS cannot propose audit adjustments for years prior to the change to the IPIC method.
3. A change to an internal index method from the IPIC method is not an automatic approval method change, and IRS audit protection is not provided to taxpayers making this change.
4. When the IRS deems a taxpayer’s LIFO calculation documentation to not be reliable now or in the past (inadequate books and records is their term for this situation), they often will make what they refer to as an “involuntary change to the IPIC method”. When they do this, they will make a pro forma calculation of all prior years’ LIFO calculation using the IPIC method and the proposed audit adjustment will be based on this calculation.

The 1982 AICPA Issues Paper referenced above was written two years before the IPIC LIFO Regs. became final because the AICPA was aware of the proposed IPIC Regs. and anticipated the question of acceptability of the IPIC method for financial statement purposes.

We believe that the issuance of the Issues Paper was a good faith attempt to deal with this issue but because the qualitative aspects of LIFO internal index calculations were ignored, the Issues Paper conclusion should no longer be considered authoritative GAAP and that the use of the IPIC method should be considered acceptable for GAAP as long the guidance provided in the IRS LIFO Regs. for the use of the IPIC method is followed.

In some cases, the use of an internal index method is deemed to be preferable for financial statement purposes because a company makes a judgement that the use of an internal index is impracticable. This happens on occasion, and we believe that a good case for this can be built for many companies but going through this process can be very time-consuming and costly. The ability to make a good decision about the quality of an internal index calculation method also requires that this decision is made by someone with substantial LIFO experience and these people are few and far between. We believe that the best solution to these problems is to rescind the conclusion arrived at in the 1982 Issues Paper. Doing so will:

1. Eliminate the situation that now exists for which most companies and CPAs do not follow the guidance of the Issues Paper, and a minority of companies follow this guidance.
2. Eliminate the substantial amount of extra time and cost required to make LIFO calculations using two different methods.
3. Eliminate the need for anyone to pass judgement about the qualitative aspects of internal index calculations.