Academic journal article Journal of Accountancy

Taking the Complexity out of Simplified LIFO

Academic journal article Journal of Accountancy

Taking the Complexity out of Simplified LIFO

Article excerpt

There's good news for companies seeking practical and cost-effective ways to deal with the difficulties of Lifo accounting. The IRS has proposed changes that would allow simplified Lifo to live up to its name for companies that operate with relatively high and volatile gross margin percentages. Outlined in IRS Bulletin 2000-23 (June 5, 2000), the proposed changes provide taxpayers an opportunity to directly use published price indexes without having to convert them to cost indexes. This will further simplify Lifo and eliminate some potentially adverse tax consequences.


Several years ago, when a client adopted the simplified Lifo inventory price index computation (IPIC) method of accounting for inventory (see glossary of terms on page 68), as originally established under Treasury regulations section 1.472-8(e)(3), the election turned out to be a mixed blessing. On the positive side, it substantially lowered the client's administration costs and eliminated the headaches tradition ally associated with Lifo computations. The client also benefited from being able to monitor the potential tax impact of changing prices throughout the year because the Bureau of Labor Statistics (BLS) publishes the relevant price indexes monthly.

But the client also experienced some fairly adverse tax consequences. The IRS has historically required taxpayers to convert a published price index to a cost index because a price index relates more to the selling prices of goods than to the cost of goods sold. In making these conversions, year-to-year variations in gross profit produced some unwelcome increases in taxable income computed on a Lifo basis, catching the company and its auditors by surprise. In retrospect, the election has not turned out to be as advantageous as the client originally hoped. With the proposed changes in IRS regulations however, the simplified Lifo IPIC method stands to become an excellent election for a host of for-profit businesses.


In computing the cost of goods sold and valuing inventories, CPAs have always faced the dilemma of choosing from several possible costs to value units of inventory accumulated at various points over time. GAAP requires that such choices be systematic and rational. In response, accountants have invoked a particular assumption about the flow of costs. For instance, Fifo assumes the first costs in are the first costs out. Under Fifo, the first costs in are included in cost of goods sold and matched against the period's revenues. A company uses the more recent inventory costs (last-in) to value any ending inventory that remains on hand.

In contrast, Lifo assumes the last costs in are the ones a company should use to measure the cost of goods sold, leaving the earliest costs to value ending inventory. Lifo offers the company the benefit of reporting lower taxable income in times of inflation. It also has the theoretical advantage of matching more current costs (those last-in) with current revenues. But a business must weigh these benefits against some of the operational difficulties of accounting for inventory on a Lifo basis.

If a taxpayer opts for the double extension Lifo method, one difficulty it faces stems from having to retain antiquated files of base year costs for all inventory items. The double extension method also presents CPAs with the challenge of having to deal with new products that did not exist in the base year inventory. Finding suitable comparable products becomes increasingly difficult as you move further away from the year of adoption. Companies could always avoid problems with the double extension method by adopting the link-chain index method. But developing an appropriate index could also be costly and complicated.

Recognizing the burdens and complexities of existing Lifo methods, the IRS provided relief in 1981 when it introduced the simplified Lifo (IPIC) method. …

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