LIFO Glossary
Absorption Costing: Method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.
Actual Costing: A costing system that traces direct costs to a cost object by using the actual direct-cost rates times the actual quantities of the direct-cost inputs and allocates indirect costs based on the actual indirect-cost rates times the actual quantities of the cost allocation bases.
Appropriate Month: This refers to which month’s CPI or PPI indexes are used to calculate IPIC method Category Inflation Indexes. IRS Reg. § 1.472-8(e)(3)(iii)(B)(3) provides rules regarding selection of “Appropriate Months”. The representative appropriate month (also referred to as representative month) is the appropriate month a taxpayer uses consistently every year as the result of their election to use the same appropriate month every year.
Average Cost: An inventory valuation method for which inventories are valued at an average of unit cost calculated for each inventory item. While there are several average cost calculation methods, the most commonly used for modern inventory accounting systems is a weighted moving average (the IRS refers to this method as the rolling average cost method) in which the average unit cost is recalculated with each inventory purchase for each item.
Base Year Cost: The amount of current year’s inventory converted to its cost in the year LIFO was adopted.
BLS: The Bureau of Labor Statistics, a division of the Department of Labor. The BLS publishes Consumer Price Indexes (CPI) in the monthly CPI Detailed Report. It also publishes Producer Price Indexes (PPI) in the monthly PPI Detailed Report. These published indexes are those used for IPIC method LIFO calculations.
Category Inflation Index: This is a term used in IRS Reg. § 1.472-8(e) to describe the LIFO index for a particular CPI or PPI category.
Conformity Requirement: An Internal Revenue Service code that requires a company that uses LIFO for income tax purposes to use LIFO for financial reporting purposes. The extent that the IRS prescribes for taxpayers to conform tax & financial reporting (book) LIFO are for the tax LIFO election scope (inventories on LIFO) to be less than or equal to the book LIFO election scope. Put in another way, the book inventories on LIFO must be greater than or equal to the tax LIFO inventories on LIFO.
Cost Component Method: A method of applying dollar value LIFO in which changes in the LIFO index are measured by the weighted average increase or decrease in the component costs of material, labor, and overhead that constitute ending inventory.
Cost LIFO: A term that describes the calculation of LIFO inventory balances by first converting cost inventory balances (current-year cost) to inventory at base balances using inflation indexes that are a measure of inflation in the cost of inventory items.
Cost Of Goods Sold: Total manufacturing cost of jobs or units sold during the period.
CPI (Consumer Price Indexes): These are price indexes compiled and published monthly by the BLS in the CPI Detailed Report. The indexes in Table 3 of this report are those which IPIC method taxpayers can use for LIFO calculations. Only retailers can use the CPI indexes for LIFO purposes although retailers can use either CPI or PPI indexes. There are over 300 CPI index categories in Table 3 and approximately 200 of these are for commodities (service category indexes cannot be used for LIFO purposes).
Cumulative LIFO Index: A LIFO index that is the measure of LIFO inflation from the base year to the current year end. For double-extension method LIFO index calculations, the cumulative index is calculated by dividing the sum of extensions at current year end prices (current year end on-hand quantity times current year end unit price) for all items or a representative sample of items by the sum of extensions at base year prices (current year end on-hand quantity times base year end unit price) for all items. For link-chain method LIFO index calculations, the cumulative index for the current year end is calculated by multiplying the cumulative index for the prior year end times the current year LIFO index. The current year link-chain LIFO index is calculated by dividing the sum of extensions at current year end prices by the sum of extensions at prior year end prices. Cumulative LIFO indexes are used to convert (by division) the current-year end inventory cost to base year dollars which is then compared to the prior year end inventory at base dollars to determine whether there is an increment or decrement for the year.
Current Year Cost: A term used by the IRS which describes the year end inventory balance that is to be converted to base year prices for companies using the dollar-value LIFO method. The current-year cost is usually the general ledger balance (for each LIFO pool) adjusted to exclude valuation reserves and to include adjustments for in-transit goods, shrink reserves, vendor discounts and other cost adjustments. The general ledger balance will usually be inventories stated at FIFO or average cost. There are four different current-year method alternatives allowed by the IRS in Reg. § 1.472-8(e)(2)(ii).
Current Year LIFO Index: A LIFO index that is the measure of LIFO inflation for the current year only. Current year LIFO indexes are used for link-chain method LIFO calculations.
Deflator Index: LIFO index used to convert or “deflate” current year cost inventory balances to inventory at base year price values.
Dollar-Value LIFO: Most commonly used LIFO inventory costing method; it determines and measures any increases and decreases in a pool in terms of total dollar value, not the physical quantity of the goods in the inventory pool.
Double-extension LIFO Method: Cumulative index method where all items are extended at current cost and base year costs. Considered an unreliable and unpredictable measure of inflation (Richardson, 2015).
Dual Indexes: A method for which the deflator and inflator indexes are not the same. Dual Index methods are no longer (since 2002) allowed by the IRS. When they were allowed, some companies used dual indexes to achieve a lower LIFO inventory valuation by using inflator indexes that reflected beginning of the year rather than end of year prices. There are no GAAP rules that preclude the use of dual indexes.
External or published indexes: The use of price indexes published by the Bureau of Labor Statistics to calculate LIFO inflation (as opposed to computing internally-calcualted inflation indexes); also is known as using the IPIC LIFO method. Under this method, applicable Consumer Price Index (CPI) or Producer Price Index (PPI) categories are assigned to inventory items & category inflation indexes are calculated using the price indexes published for each individual BLS category. After all items have been assigned BLS categories, the harmonic dollars weighted extension is calcualted to derive a weighted-average pool index.
FIFO: This is an acronym for “first in, first out” which is an accounting method for determining the cost of inventories. Under this method, the first items purchased are treated as being the first items sold. Period end inventories are valued using the unit cost of the last purchases made on an item-by-item basis.
Full Absorption Costing: Costing method required for external reporting (GAAP) in which product costs reflect the full cost of manufacturing.
Historical Cost: The amount paid or liability incurred by an accounting entity to acquire an asset and make it ready to render the services for which it was acquired.
Inflator Index: LIFO index used to multiply times (or “inflate”) layer (or increment) at base prices to produce a layer valued at LIFO cost. The inflator index used to value layers will be the same as the deflator index except, when a dual index method is used.Inflator index – LIFO index used to multiply times (or “inflate”) layer (or increment) at base prices to produce a layer valued at LIFO cost. The inflator index used to value layers will be the same as the deflator index except, when a dual index method is used.
Internal Index: A term used to describe a non-IPIC index calculation method which entails using that company’s actual unit prices to calculate LIFO indexes.
Inventory Item: Unit of inventory measurement for which LIFO inflation is measured for non-IPIC (internal index) LIFO methods. The inventory item is usually SKU (stock keeping unit) or goods with unique UPC (universal product code) codes for retailers and wholesalers. Some taxpayers define for LIFO inflation measurement purposes their inventory items to be the number of pounds of nails or board feet of similar types of lumber, e.g. The broader the definition of inventory item, the more IRS scrutiny is likely as to the appropriateness of item definition.
Inventory Price Index (IPI): This is a term used in IRS Reg. § 1.472-8(e)(3)(i) to describe a pool’s weighted average index for taxpayers using the IPIC method. For link-chain taxpayers, a pool’s IPI is multiplied times that pool’s previous year’s cumulative deflator index to produce the current year’s cumulative deflator index, which is then used to “deflate” current year cost balances to base year prices.
Inventory Price Index Computation (IPIC) Method: The Inventory Price Index Computation (IPIC) method was authorized by IRS Reg. § 1.472-8(e) in 1982. This method permits taxpayers to use of price indexes published by the Bureau of Labor Statistics to calculate LIFO inflation (as opposed to computing internally-calcualted inflation indexes); Under this method, applicable Consumer Price Index (CPI) or Producer Price Index (PPI) categories are assigned to inventory items & category inflation indexes are calculated using the price indexes published for each individual BLS category. After all items have been assigned BLS categories, the harmonic dollars weighted extension is calculated to derive a Weighted-Average Pool Index that are subsequently used to compute the other LIFO variables needed to calculate the LIFO inventory and reserve balances.
Involuntary LIFO Termination: The termination of a taxpayer’s LIFO election by the IRS. The IRS Regs. allow the IRS to terminate a taxpayers LIFO election for the following reasons: 1) improper LIFO election, 2) violation of LIFO conformity Regs., 3) the current-year cost of inventories used for the LIFO calculation that are net of valuation reserves and 4) inadequate books and records maintained to adequately document the calculation of LIFO indexes and LIFO inventory balances.
IRS Form 970: Application to Use LIFO Inventory Method. A Form 970 is required for:
IRS Form 3115: Application for Change in Accounting Method -Taxpayers must file Form 3115 for LIFO-related methods changes including: Change from LIFO to a non-LIFO method (also referred to as LIFO termination) Change from one LIFO method to another LIFO method Change from one LIFO pooling method to another LIFO pooling method.
Last-In, First-Out (LIFO) Method: Assumes a last-in, first out flow of cost. Results in the lowest taxable income during periods of inflation because it results in the highest cost of goods sold and the lowest inventory value. Price indexes are used for the valuation.
LIFO Conformity: The “LIFO conformity” rules are that section of the IRS Regs. (IRS Reg. § 1.472-2) that requires the use of the LIFO method for financial reporting purposes for those inventories for which the LIFO method is elected for tax purposes.
LIFO Decrement: The excess of the prior period end inventory at base minus the current period end inventory at base. Decrements result in reduction or “erosion” of increments or layers created in earlier years and therefore a LIFO layer is not created for years that have decrements. A LIFO decrement is not the same as a decrease in the LIFO reserve compared to the prior year LIFO reserve (this is referred to as LIFO income).
LIFO Effect: The change from one period to the next in the balance of the account (Allowance to Reduce Inventory to LIFO, also called the LIFO reserve) that companies use to record the difference between the non-LIFO inventory method used for internal-reporting purposes and LIFO used for tax or external-reporting purposes.
LIFO Election Scope: The inventories for which the LIFO method is used. Neither the IRS Regs. nor GAAP requires that the LIFO method be used for all inventories when the LIFO method is used. Situations for which the LIFO election scope does not encompass all inventories are referred to as “partial” or “selective” LIFO elections.
LIFO Expense: This is the difference between the current period end LIFO Reserve and the previous period end LIFO Reserve (LIFO Expense = current period end LIFO Reserve – previous period end LIFO Reserve). This is the amount that taxable income or financial reporting pre-tax income has been reduced by for the current period by using LIFO.
LIFO Income: This is the difference between the current period end LIFO Reserve and the previous period end LIFO Reserve (LIFO Expense = current period end LIFO Reserve – previous period end LIFO Reserve). This is the amount that taxable income or financial reporting pre-tax income has been reduced by for the current period by using LIFO.
LIFO Increment: The excess of the current period end inventory at base minus the previous period end inventory at base. This is also referred to as a “LIFO layer”. A LIFO increment is not the same as LIFO income which results from an increase in the LIFO reserve.
LIFO Index: A ratio expressed in decimal format that is the measure of LIFO inflation for each LIFO pool for taxpayers using dollar-value LIFO.
LIFO Layer: A LIFO layer is the same as a LIFO increment.
LIFO Liquidation: Erosion of the LIFO inventory under a specific-goods (unit LIFO) approach. Such erosion matches costs from preceding periods against sales revenues reported in current dollars, which often distorts net income and leads to substantial tax payments.
LIFO Pools: Inventory items that are similar in their end-use are grouped together to form a LIFO Pool. IRS Code Reg. §§ 1.472-8(b), (c) & (d) requires companies with more than one LIFO Pool using the dollar-value LIFO method make separate LIFO inflation measurements and LIFO reserve calculations for each defined LIFO Pool. There are several different methods of grouping inventory items into LIFO pools allowed by the IRS.
LIFO Reserve: This is the difference between the FIFO or average cost value of inventory and the LIFO value of inventory (LIFO Reserve = FIFO – LIFO). The LIFO Reserve is a measure of the cumulative amount that a company’s taxable income or financial reporting pre-tax income has been reduced by using LIFO since the method was first adopted. The general ledger contra asset account(s) used to record this difference is also referred to as the LIFO reserve.
Link-chain LIFO Method: Cumulative index method where items are extended at current cost and prior-year cost. The current year index is then “linked” to the prior-year cumulative inflation index.
Lower of Cost or Market Reserve(LCM): Another term for market write-downs or inventory valuation reserve. The IRS requires market write-downs to be eliminated for LIFO inventories in Reg. § 1.472-2(b).
Natural Business Unit: A LIFO pool, used under dollar value LIFO generally comprising the entire production capacity of the enterprise integrated vertically within one product line, or two or more related product lines, including any material procurement, processing of materials, and selling the produced goods.
New Items: New items are inventory items that were purchased for the first time during the year and are on hand for the current year end. New items present a problem for internal index calculations because the inventory accounting system has no record of a prior year end unit price for the new item.
Period Costs: All costs in the income statement other than cost of goods sold.
Periodic Inventory System: Relies upon an occasional physical count of the inventory to determine the ending inventory balance and the cost of goods sold.
Perpetual Inventory System: Keeps continual track of inventory balances as sales and inventory purchases occur.
Reconstructed Cost: The amount at which items in inventory would have been priced if they had been acquired in the base year.
Replacement Cost: The current cost of replacing inventory or any reasonable approximation, which may be FIFO or average cost, at the lower of cost or market.
PPI (Producer Price Index): These are retail price indexes compiled and published monthly by the BLS in the PPI Detailed Report reflecting average prices paid producers (manufacturers and processors) for inventory purchase/sales transactions. The indexes in Table 9 of this report are those which IPIC method taxpayers can use for LIFO calculations (Table 11 indexes can be used but only if it is a better fit for the inventory item in question than any Table 9 index). There are approximately 2,500 commodity PPI index categories in Table 9 (service category indexes cannot be used for LIFO purposes).
Retail Inventory Method (RIM): Inventory accounting method historically used by many retailers whereby merchandise department cost balances are calculated by multiplying departmental cost complements (of gross profit margins) times departmental retail inventory balances because maintaining perpetual inventory records by item is not practical. Physical inventories for companies using the RIM method are taken using marked retail selling prices. The IRS refers to this method as the “retail cost” method on Form 3115 Schedule D, Part II, line 4a (page 6).
Retail LIFO: Retail LIFO – A term that describes the calculation of LIFO inventory balances by first converting retail inventory balances (the current-year cost) to retail basis inventory at base balances using inflation indexes that are a measure of retail price inflation. Layers at retail are then reduced to cost by multiplying them times the LIFO cost complements calculated for each pool.
Simplified LIFO: Simplified LIFO is often a misnomer used to describe the IPIC LIFO Method. Simplified LIFO is actually a term the IRS used to describe a more simplified LIFO method applicable only to very small businesses provided for in Reg. § 1.474 starting in 1981 but this Section became superseded after 1986.
Specific-Goods LIFO: Also known as “Unit LIFO”; an approach to applying LIFO in which changes in the quantity of individual types of inventory are the basis for determining whether the inventory levels have increased or whether a portion of the existing inventory has been liquidated. Doing this almost always guarantees lower LIFO benefits for a company because LIFO is applied on an item-by-item basis. LIFO layer erosions (causing reduction of previous years’ LIFO benefits) occur for every item each year there are fewer units on hand compared to the prior year because there is essentially a LIFO pool for each item. With dollar-value LIFO, pools are established for broad types of goods so increases and decreases in items on hand are netted together which results in fewer LIFO layer erosions.
Substitute Base Year: A technique in which beginning of year costs in the year of change are used instead of the base year’s costs to determine changes in dollar value LIFO pools.
UNICAP Costs: This is the amount of labor and overhead that IRS Reg. § 263A requires taxpayers to capitalize as an add-on to inventory balances in addition to labor and overhead costs capitalized as required by GAAP. In other words, these are inventory related costs for which the IRS requires treatment as product cost rather than period cost. These costs are also referred to as Sec. 263A costs.
Unit Cost: Cost computed by dividing total cost by the number of units. Also called average cost.
Unit Cost Method: A method of applying dollar value LIFO in which changes in the LIFO index are measured by the weighted average increase or decrease in the unit cost of raw materials, work in process, and finished good inventories.
Unit LIFO: See Specific-Goods LIFO.
Weighted Arithmetic Mean: A method for calculation of weighted average pool indexes whereby current year cost balances are multiplied times the current year inflation index for that CPI or PPI index category to determine an Arithmetic Mean “extension”. The pool index is calculated by dividing by the sum of the Arithmetic Mean extensions for all index categories by the sum of the current year cost. This method was used by most taxpayers prior to the issuance of the new IPIC LIFO Regs. in 2002.
Weighted-Average Pool Index: IPIC LIFO pool current year inflation index calculated by dividing sum of the current year cost for all index categories by the sum of the Harmonic Mean extensions. This is used to subsequently compute the other LIFO variables needed to calculate the current year LIFO inventory and reserve balances.
Weighted Harmonic Mean: The math prescribed by IRS Reg. § 1.472-8(e) to calculate weighted-average pool indexes for the IPIC method. Weighted Harmonic Mean math entails “deflating” current year cost balances to prior year prices by division of the current year cost by the current year inflation index for that CPI or PPI index category to determine a Harmonic Mean “extension”. The weighted-average pool index is calculated by dividing sum of the current year cost for all index categories by the sum of the Harmonic Mean extensions.
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