Inventory costs are rising (i.e., there is inflation) and LIFO accounting provides a more accurate way of measuring financial performance and calculating tax.

Inflation is in the news. After a more than 15-year hiatus, inflation’s return has been documented in recent months by nearly every business journal in the nation. Economists are examining economic data and concluding that inflation is knocking, once again, at America’s front door. While most view inflation by only its clear downsides, there is at least one tool that CPA’s can use to help turn a negative into a positive for businesses: The Last In, First Out (“LIFO”) accounting method.

With so many years of little to no inflation, LIFO accounting has been largely relegated to accounting classrooms and cost flow textbooks; but now, LIFO is making a comeback. CPA’s are realizing this is the perfect time to begin evaluating the tax benefits that can be obtained through this IRS-accepted methodology.

Why should businesses, already using this accounting method or not, re-consider LIFO? Regulations issued in 2002 provide favorable opportunities to both LIFO and non-LIFO taxpayers. Becoming familiar with the basic concepts of LIFO and the updated rules will enable the practitioner to:
1) Potentially maximize the tax benefits available to clients or businesses that are already on LIFO;
2) Provide audit protection to clients or businesses that currently use an internally generated LIFO inflation index; and
3) Make a substantial tax benefit available to clients or businesses that have not yet taken advantage of LIFO.

What is LIFO?
LIFO at its core is a cost flow methodology. Under the LIFO method, costs move through inventory in a manner that allocates the most recent costs incurred to cost of sales, while retaining the earliest costs in inventory. Essentially, the most recent purchases, for a retailer/distributor, or manufactured goods, for a manufacturer, are the items considered sold during the current period.

Consider a grocery store example: Most shelved items are stocked from front to back and sold in the same manner (our example assumes inventory is not rotated). The oldest items are retained at the back of the shelf and will only be sold if quantities diminish significantly. At the end of any reporting period, those items remaining on the shelf are likely to have been purchased at a lower rate than those items most recently purchased and sold before the end of the period. Just as in the grocery store, old items under the LIFO methodology are not likely to be sold. The lower costs associated with the older items are retained in inventory and work to keep ending inventory small.

The LIFO cost flow assumption contrasts sharply with the other common inventory methodology, First-In-First-Out (FIFO). Under the FIFO method, the costs of items sold in the current period are considered to be the earliest costs in inventory prior to the sale. While this methodology most closely resembles the natural movement of goods, it generally doesn’t value ending inventory at the lowest possible amount. Why? As prices naturally rise, current, more expensive, costs are held in inventory under the FIFO method as compared to the LIFO method.

A significant benefit associated with LIFO is that it attempts to match current costs with current revenues. Current purchases or manufacturing costs are linked directly to current sales. To this end, LIFO’s true advantage over the FIFO method is its effectiveness in reducing the impact of price increases on profitability. With all things being equal, after successive annual price increases the value of ending inventory is likely to be substantially less than current replacement costs.

Acronyms to Know: IPIC LIFO Uses PPI and CPI
Like other dollar value LIFO methods, the Inventory Price Index Computation (“IPIC”) LIFO method compares current year costs with base year costs to develop an index. Unlike other dollar value LIFO methods, the IPIC method uses external government published indexes rather than indexes that are a result of a business’ internal prices.

The IPIC method utilizes the same indexes tracked and reported by our most trusted cable financial networks and business publications, the Producer Price Index (PPI) or Consumer Price Index (CPI). Every item produced or sold in this country is tied to these government-published indexes. The IPIC method first links a company’s inventory to categories within the PPI and CPI. It then compares the change in these indexes from the beginning of a company’s tax year to the end of the tax year to determine current year inflation. Lastly, each item’s inflation is weighted by the dollar value of the item to the total dollar value of ending inventory to determine an overall inflation index. This index represents the overall change in inventory prices from the beginning of the year to the end of the year.

What’s so special about using external indexes under the IPIC method? There are three primary answers to this question: simplification, IRS acceptance, and the possibility of additional tax savings.

Simplification – Implementation of the IPIC LIFO method allows businesses the benefit of LIFO without tracking price changes for all of its many inventory items, which often total in the thousands. Internal recordkeeping is significantly diminished when a detailed inventory listing linked to PPI or CPI categories is all that is needed to compute current year inflation. Some companies spend weeks rebuilding prices in order to perform a LIFO calculation that may or may not result in a benefit. Under IPIC, beginning indexes from the prior year are already known; the company only needs to populate year-end indexes.

IRS Acceptance – The IRS understands the IPIC LIFO methodology and actually approves of the method. With the issuance of the new §472 regulations effective for taxable years ending on or after December 31, 2001, Treasury further simplified the IPIC method and reiterated its desire for companies to move to the IPIC method by giving audit protection to businesses’ prior methods if they would simply convert to the IPIC method. Retailers, manufacturers and even companies dealing in commodities have been encouraged by the IRS (sometimes upon audit) to switch to the IPIC method.

Additional Benefit – Many taxpayers realize lower inventory values and better tax savings under the IPIC LIFO method. Whether switching cost flow methods from FIFO to LIFO or simply moving from an existing internal LIFO method, the IPIC LIFO method has the potential to increase current and future year deductions by reducing ending inventory compared to other methods.

External indexes are a composite of the entire industry, specifically domestic production and consumption. Participants in the industry are asked to share their cost/price experience. The PPI or CPI directly reflects this information. Companies that are more efficient in manufacturing operations or that can secure lower purchase prices from their suppliers usually see less internal inflation as compared to their overall industry. Thus, the external indexes give them a better result because inflation is a good thing where LIFO is concerned. In addition, the IPIC method is somewhat flexible in its use of sub-methods. Where there is choice and flexibility, there is opportunity.
Why Consider LIFO Now?
Why should businesses not already on LIFO consider it now? One word: Inflation. No doubt you and your clients have been reading about it in the “Wall Street Journal”. It’s back and according to many leading economists, it’s here to stay.

Inflation has a material impact on business. Going back to the grocery store example, if the items being stocked at the front of the shelf cost more than the items at the back of the shelf and these are the items that are sold, cost of goods sold will be higher and ending inventory lower. Higher cost of goods sold means higher current period expense and less tax. What better way to mitigate the precarious profit siphoning aspect of inflation?

Keys to Implementing a Successful IPIC LIFO Implementation
There are several ways for an accounting firm to help their clients or company take advantage of this opportunity. First, developing an understanding of Treasury Regulations §1.472-8 is necessary to understand how to properly apply the IPIC method. Whether implementing in-house or using a third party provider, the key questions should include:
1. Are inventory items properly classified to the most detailed PPI or CPI categories?
2. What pooling methodology is most appropriate?
3. Which month is “appropriate” for use in determining the annual inflation index by pool?
4. Should a “representative” month be chosen as opposed to an “appropriate” month?
5. Which indexes, preliminary or final, should be chosen to measure inflation?
6. Does the “10% grouping” option yield a lower inventory value for the business?

Answers to these questions and subsequent implementation decisions will make a substantial difference in the amount of benefit realized from an IPIC LIFO implementation. Proper analysis of these variables, through objective modeling, is worth the time and effort spent on the exercise.

Inflation is making its grand entrance into the boardrooms of many businesses in the country, but LIFO can help mitigate the negative impact of inflation. The LIFO accounting method is the CPA’s best defense against inflation. And, whether already on LIFO or not, the IPIC method makes LIFO even more desirable for today’s businesses.

Chris Henderson, CPA is the Operations’ Director for SourceCorp Professional Services and TSCPA member. SourceCorp specializes in LIFO Accounting, R&D Tax Credits, Cost Segregation Studies, and 179D Studies. Since 1983, SourceCorp Professional Services is recognized as an industry leading LIFO provider to thousands of CPA firm offices across the nation.

About SourceCorp:
SourceCorp Professional Services is a leader in specialized tax services to accounting firms including LIFO Accounting, R&D Tax Credits, Cost Segregation Studies, and Energy Efficiency Building Studies under §179D. Founded in 1983, SourceCorp is the only company in the U.S. that provides these services based on long-term relationships, value-creating resources, and responsible action. With sales offices throughout the US, accounting firms realize unparalleled access to specialized tax service professionals in all major cities. For more information, please visit: SourceCorpTax.com.