The vast majority of companies on LIFO use a method called dollar-value LIFO. Under this method, the calculation of the LIFO reserve occurs as a side-calculation that occurs in two distinct steps, the first being the current year inflation calculation (front end) & the LIFO reserve calculation (back end). The front end of the LIFO calculation relies on comparing current and prior/base year costs & weighting the calculation using year end quantities on hand. The back end of the LIFO calculation uses the front end calculation outputs to determine whether a new LIFO layer has been created (or if one or more layers have been eroded), the amounts of increments/decrements at base year & LIFO cost, and to ultimately arrive at the current year’s LIFO inventory & reserve balances.
For the front end of a dollar-value LIFO calculation, there are two inflation measurement sources or options are available for completing the annual inflation calculation. Those two options are described below:
- Internal Indexes: Relies on the costs established & internally managed within a company’s accounting information system to calculate inflation. Involves the following steps:
- Double-extending the current period’s quantity on hand with the current & prior/base period unit or item costs
- Adding the sum of the current & prior/base period extensions
- Dividing the sum of the current period’s extensions by the prior/base period extensions by LIFO pool to calculate a weighted-average pool index (or indexes if multiple LIFO pools exist).
- External Indexes: Relies on using Consumer or Producer Price Indexes published by the Bureau of Labor Statistics to calculate inflation. Also known as the IPIC method. Involves the following steps:
- Assigning BLS CPI/PPI categories to all items on hand
- Developing a breakdown or sum of the extended cost balances of all goods on hand at period end by BLS CPI/PPI category
- Obtaining the appropriate current & prior/base period BLS CPI/PPIs for all categories present at period end
- Dividing the current & prior/base period BLS CPI/PPIs to calculate category inflation indexes for all BLS categories on hand at period end
- Dividing the sum of the extended cost for each BLS CPI/PPI by its category inflation index to calculate the harmonic dollars weighted quotients
- Summing the extended cost balances of all goods on hand at period end by the sum of the harmonic dollars weighted quotients by LIFO pool to calculate a weighted-average pool index (or indexes if multiple LIFO pools exist).
Inflation Measurement Source Pros & Cons
- Internal Indexes
- Pros
- Inflation calculated is most clearly reflective of income since it should match the experience of the company whose internal costs are being use to calculate the inflation
- Precludes the need to assign BLS CPI/PPI categories: For companies with diverse product mixes, large amount of unique items & multiple stages of production, the effort required to assign BLS CPI/PPI categories to their goods can be extensive. For IPIC PPI users, this effort can be especially time-intensive since there are approximately 3,000 BLS commodities. This means that a company with many different types of items that uses PPI will have a large number of BLS categories applicable to their product mix, and in the absence of LIFO software or a turnkey outsourcing solution, the process of PPI code assignments & calculating category inflation indexes is especially burdensome (many companies whom maintain internal groupings at a level that is higher than the most detailed level will assign BLS CPI/PPIs by their product hierarchies, such as class, type, product family, line etc. Accordingly, this can materially reduce the effort required to assign BLS categories; furthermore, only new items need to be assigned BLS category assignments have been made to preexisting items in the the first year that the IPIC method is used)
- Precludes the need to obtain government price indexes from external sources – For IPIC LIFO users, current & prior period CPI/PPIs must be downloaded from the BLS website in order to calculate category inflation indexes. For companies using a large number of BLS categories, the task of periodically downloading & maintaining their external index calculation data can be very cumbersome.
- Current year index can be less complicated than external indexes in certain situations: For IPIC LIFO users whom also use what’s called the 10% method, the calculation of the category inflation indexes becomes especially complicated in the absence of LIFO software or a turnkey outsourcing solution. Accordingly, compared to an internal inflation index calculation, IPIC method calculations under the 10% method in situations where there are large numbers of BLS categories and/or LIFO pools may result in more effort.
- Often provides more favorable financial reporting results when compared to external indexes: As described below in the Pros section of the external index bullets, the use of an internal index often creates less inflation & a lower LIFO reserve than an external index. As a result, the effect of using an internal index for financial reporting can be viewed as favorable not only because it most closely matches a company’s actual experience, but it will also create for a lower LIFO charge to be recognized in the calculation of income & earnings when compared to an external index. Many publicly-traded companies use an internally calculated index for financial reporting or book LIFO, but use an external index for tax purposes. As a result, the internal index inflation calculated for book LIFO creates less inflation & results in a lower LIFO reserve. For financial reporting, recognizing less LIFO expense is considered favorable on the income statement, but at the same time, making the use of an internal index often more desirable for book LIFO. At the same time, many companies will use an external index for tax purposes only in order to maximize the LIFO reserve reported on the tax return. The result in such cases is a favorable book-tax LIFO reserve difference, which allows for the best of both worlds to be achieved on both fronts.
- Cons
- Often creates less favorable tax LIFO benefits compared to an external index when internal index inflation & LIFO reserve is lower than those of external index
- More documentation is required to maintain adequate internal vs. external index LIFO books & records: See LIFOPro’s blog regarding LIFO books & records: IRS Auditing More LIFO Calculations Following LIFO Records Practice Unit Release
- Increased reliance & audit scrutiny placed on the accuracy of a company’s internal product costs
- Often increased reliance placed on IT department to support internal index calculation when compared to external index
- Interim estimates can often be more complicated to complete when compared to an external index
- Pros
- External Indexes
- Pros
- External indexes have historically created more inflation & materially higher LIFO reserves than internal indexes: The most predominant reason as to why external index inflation can be consistently higher than internal indexes is the differential that exists between the inflation in imported vs. exported goods. For external indexes, the BLS only surveys domestic production & consumption, and especially with the PPI, the domestic production costs are higher than those of the costs for items produced and/or sourced from abroad. With internal indexes, many companies source their raw materials from abroad which are often obtained at costs that are lower compared to the costs of domestically sourcing the raw materials. Furthermore, many domestic business purchase goods for resale that are sourced from abroad. As a result, the internal index inflation often results from having imported products with less an inflation than the domestically produced goods captured within external indexes.
- IRS offers audit protection from certain past LIFO calculation errors following switching to the IPIC method: For companies with an error or errors in past internal index inflation calculations, the IPIC method acts as a safe harbor since the IRS is precluded from proposing an adjustment to the taxpayer’s LIFO reserve once a switch to the IPIC method has ben made.
- Switch to the IPIC method is made prospectively, meaning no prior period adjustments to the LIFO reserve are required & the change is applied beginning in the year of change: For Since the IRS considers an error made in an internal index calculation for two or more consecutive periods to be an unauthorized change in accounting method that can’t be corrected, such an error that caused a LIFO reserve overstatement provides the taxpayer the opportunity to carry forward their pre-change LIFO reserve forward while being afforded audit protection from the prior period errors following an accounting method change to the IPIC method
- Switch to the IPIC method is automatic approval: This means the following:
- Application to change to the IPIC method only requires for a Change in Accounting Method IRS Form 3115, but upon filing, the taxpayer receives automatic consent from the IRS to apply the change
- The decision to switch to the IPIC method can be made after the end of the tax year, and the taxpayer has until their Form 1120 filing deadline to apply the change
- No IRS Users fee is required to implement the change
- Precludes the need to rely on internally-managed costs: For many companies, inventory costing involves a myriad of components, and for manufacturers, additional burdens exist to incorporate components of cost such as labor & overhead into the computation of unit or standard costs. As a result, many companies find relying on external indexes published by the government to be preferable to their internally-developed products costs for purposes of calculating inflation. Furthermore, since a government agency bears the primary responsibility for providing the inputs of to complete external index inflation calculations, there is a lower amount of audit risk related to the reasonableness of such calculations. For example, if a link-chain internal index calculation created 200% inflation for a certain item, the burden is on the company to prove that the quantities & current/prior period unit costs used to calculate that inflation index was reasonable. On the other hand, 200% inflation being calculated using an external index will typically go unquestioned since the inputs used to calculate that inflation comes from the BLS & not a company’s internally calculated costs.
- Provides a simpler means of performing interim estimates: Most companies have a desire to perform interim estimates at least once a year. Many others have the need or motivation to perform quarterly estimates, and there are some that even perform monthly interim estimates. For companies using the IPIC method, interim estimates are easier to obtain than internal indexes because IPIC interim estimates can be performed without generating current period item detail reports. Under the IPIC method, the majority of companies simply use their prior period’s product mix & year to date CPI/PPI inflation to complete their interim estimates. As a result, companies using the IPIC method can avoid the administrative burden involved with generating current period item detail reports to calculate inflation, and furthermore, those using software or outsourcing their LIFO calculation to perform IPIC interim estimates can do so with a minimal amount of work. For internal index interim estimates, companies must take the following steps to perform interim estimates:
- Take the same steps used to perform a full year end LIFO calculation: This involves generating current period item detail reports containing current period quantities on hand & unit costs in order to calculate an interim period inflation rate.
- Developing a projected inflation rate without performing a full year end inflation calculation: For many companies, taking such an approach would include taking into consideration the following factors:
- Suppliers whom have already implemented changed prices between year end & date of estimate
- Anticipated price changes to occur between date of estimate & year end
- Public information from industry competitors, economists & commodities experts regarding current & future price changes
- Cons
- Index calculation can be subjected to scrutiny when GAAP financial statements are audited or reviewed since inflation calculated may not match the price changes being experienced internally
- Requires BLS CPI/PPI category assignments: For companies with diverse product mixes, large amount of unique items & multiple stages of production, the effort required to assign BLS CPI/PPI categories to their goods can be extensive. For IPIC PPI users, this effort can be especially time-intensive since there are approximately 3,000 BLS commodities. This means that a company with many different types of items that uses PPI will have a large number of BLS categories applicable to their product mix, and in the absence of LIFO software or a turnkey outsourcing solution, the process of PPI code assignments & calculating category inflation indexes is especially burdensome (many companies whom maintain internal groupings at a level that is higher than the most detailed level will assign BLS CPI/PPIs by their product hierarchies, such as class, type, product family, line etc. Accordingly, this can materially reduce the effort required to assign BLS categories; furthermore, only new items need to be assigned BLS category assignments have been made to preexisting items in the the first year that the IPIC method is used)
- Requires government price indexes to be obtained from external sources – For IPIC LIFO users, current & prior period CPI/PPIs must be downloaded from the BLS website in order to calculate category inflation indexes. For companies using a large number of BLS categories, the task of periodically downloading & maintaining their external index calculation data can be very cumbersome.
- Current year index can be more complicated than external indexes in certain situations: For IPIC LIFO users whom also use what’s called the 10% method, the calculation of the category inflation indexes becomes especially complicated in the absence of LIFO software or a turnkey outsourcing solution. Accordingly, compared to an internal inflation index calculation, IPIC method calculations under the 10% method in situations where there are large numbers of BLS categories and/or LIFO pools may result in more effort.
- Often provides less favorable financial reporting results when compared to internal indexes
- Pros
Key Considerations
- The IPIC method is an IRS safe harbor method & therefore less prone to scrutiny upon audit since it relies on government price indexes (whereas internal indexes use actual product costs; IRS can require taxpayer to provide supporting documentation behind inflation calculation such as invoices & additional accounting records)
- Turnkey Outsourcing Solutions & LIFO Software exists to simplify all LIFO calculations
- Many companies use external indexes for both financial reporting & tax to avoid having to maintain separate book & tax LIFO calculations
- Some companies maintain separate book & tax LIFO calculations in order to use internal index for financial reporting, and external indexes for tax for one or both of the following reasons:
- Auditors may require for the preferable inflation measurement source to be used for GAAP purposes in order to be most clearly reflective of income
- Least amount of LIFO expense desired to be recognized on financial statements, which oftentimes is accomplished by using internal index
- For tax purposes, switch to the IPIC method is automatic approval & change is made prospectively, meaning switch is applied beginning in year of change & no prior period adjustments are required
- For book purposes, switch from internal to external index inflation measurement source may be considered a change in accounting principle, and if practicable & material, financial statement auditors may require for retrospective accounting to be applied
Get a Free Best LIFO Practices & Review from LIFOPro today!
- Comes in the form of a PDF report & features the following items:
- LIFO books & records adequacy review
- LIFO calculation review
- LIFO methods compliance review
- Best LIFO practices review
- Tax deferral maximization strategies, including:
- Pro forma LIFO calculations of proposed vs. present LIFO submethods
- Comparing results between using an internal vs. external inflation measurement source
- LIFO policies & procedures development, improvement & simplification strategies, including:
- Switching from internal to external inflation measurement source (aka IPIC method)
- Automation and/or outsourcing opportunities
- LIFO submethod optimization strategies
- Tax deferral maximization strategies, including:
- Findings & recommendations
- Request your review or learn more here: Best LIFO Practices & Review Report