What is the LIFO Conformity Rule?
IRS Reg. §1.472-2(e)(1) requires for taxpayers using the LIFO method to also do so for financial reporting purposes beginning in the year that LIFO is adopted for tax purposes (LIFO can be adopted for financial reporting purposes prior to the adoption for tax purposes, but not vice versa). What is commonly overlooked though is the fact that different book & tax LIFO methods can be used. IRS Regs. explicitly state the following: §1.472-2(e)(8): LIFO Conformity Rule
Use of Different Methods
The following are examples of costing methods and accounting methods that are neither inconsistent with the inventory method referred to in § 1.472-1 nor at variance with the requirement of § 1.472-2(c) and which, under paragraph (e)(1)(vi) of this section, may be used to ascertain income, profit, or loss for credit purposes or for purposes of financial reports regardless of whether such method is also used by the taxpayer for Federal income tax purposes:
(i) Any method relating to the determination of which costs are includible in the computation of the cost of inventory under the full absorption inventory method.
(ii) Any method of establishing pools for inventory under the dollar-value LIFO inventory method.
(iii) Any method of determining the LIFO value of a dollar-value inventory pool, such as the double-extension method, the index method, and the link chain method.
(iv) Any method of determining or selecting a price index to be used with the index or link chain method of valuing inventory pools under the dollar-value LIFO inventory method.
(v) Any method permitted under § 1.472-8 for determining the current-year cost of closing inventory for purposes of using the dollar-value LIFO inventory method.
(vi) Any method permitted under § 1.472-2(d) for determining the cost of goods in excess of goods on hand at the beginning of the year for purposes of using a LIFO method other than the dollar-value LIFO method.
(vii) Any method relating to the classification of an item as inventory or a capital asset.
(viii) The use of an accounting period other than the period used for Federal income tax purposes.
(ix) The use of cost estimates.
(x) The use of actual cost of cut timber or the cost determined under section 631(a).
(xi) The use of inventory costs unreduced by any adjustment required by the application of section 108 and section 1017, relating to discharge of indebtedness.
(xii) The determination of the time when sales or purchases are accrued.
(xiii) The use of a method to allocate basis in the case of a business combination other than the method used for Federal income tax purposes.
(xiv) The treatment of transfers of inventory between affiliated corporations in a manner different from that required by § 1.1502-13.
Why do Companies Use Different Book & Tax LIFO Methods?
In many cases, the use of an external index inflation measurement source creates more inflation than an internal index (external index is aka the IPIC method, which uses Bureau of Labor Statistics Consumer/Producer Price Indexes or BLS CPI/PPI). Since the value of the LIFO reserve is directly correlated to the amount of inflation, when the IPIC method creates more inflation than an internal index, it also results in the highest LIFO reserve amongst the two alternatives. See LIFOPro’s blog to learn more about the IPIC method: How the IPIC Method Could Help Maximize Your LIFO Reserve
In certain cases where companies wish to minimize their book LIFO reserve and maximize their tax LIFO reserve, a strategy is sometimes employed to use an internal inflation measurement source for financial reporting purposes and the IPIC method for tax purposes (if the IPIC method has historically been and is also expected to create more inflation than internal indexes). Under such a strategy, the financial reporting impact of LIFO is minimized, and the tax benefit is maximized. This strategy is desirable in the following situations:
- Maximizing earnings per share or profitability is desired
- Lender covenants or supplier agreements require for certain ratios to be met that could be negatively affected by LIFO
How Common are Different Book & Tax LIFO Methods Used?
It is most common for uniform book & tax LIFO methods to be used because it minimizes the administrative burden related to LIFO. With that being said, it’s most common for publicly traded companies to use different book and tax LIFO methods. This is because since the primary directive for public companies is to maximize shareholder value and EPS, these companies will go to any length to minimize the impact of LIFO on their financial statements, and they also desire to maximize their tax LIFO benefits since this in turn improves net cash flow in periods of inflation.
What are the Most Common Differences in Book and Tax LIFO Methods?
- Inflation measurement source – This method is different more often than any other LIFO sub-method because of the reasons described in the above section. In most cases, when different inflation measurement sources are used, companies will use internal indexes for financial reporting and the IPIC method for tax purposes
- Pooling method – Since the use of the IPIC method to calculate LIFO inflation also often entails the use of the IPIC pooling method, the pooling method will often be different when the IPIC method is used for tax purposes and internal indexes are used for book LIFO (IPIC pooling method is rarely used when internal indexes are used)
- Current-year cost value – In certain cases, non-LIFO reserves and write-downs are included in determining the value of ending inventory for financial reporting purposes (since GAAP calls for inventories to be valued at the lower of cost or market). In these cases, the tax Current-year cost value will be different than the book value because IRS Regs. requires for the tax Current-year cost to be valued at cost rather than lower of cost or market, so non-LIFO inventory reserves/write-downs cannot be applied to determine this cost.
Pro Forma IPIC LIFO Case Studies
LIFOPro offers free pro forma IPIC LIFO Case Studies to compare the difference between using an internal vs. external index. Included in your free case study is as follows:
- Current year internal index calculation using company’s actual costs
- Current year external index calculation using Bureau of Labor Statistics Consumer/Producer Price Indexes
- 20-year pro forma IPIC calculation using current period’s product mix & inventory balances
- Current year & 20-year comparative results
- Recommendations regarding the most beneficial tax LIFO method to utilize
Get your free IPIC LIFO Case Study today or contact LIFOPro to learn more!
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