Taking the Complexity Out of Simplified Lifo

EXECUTIVE SUMMARY

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. The changes, outlined in IRS Bulletin 2000-23, allow taxpayers to use public price indexes without having to convert them to cost indexes. COMPANIES THAT HAD ADOPTED THE SIMPLIFIED LIFO IPIC method of accounting for inventory found the election a mixed blessing. Converting a published price index to a cost index resulted in some unwelcome increases in taxable income as a result of year-to-year variations in gross profit. WHILE THE 1981 INTRODUCTION OF THE SIMPLIFIED LIFO IPIC method helped some companies by producing a highly predictable Lifo adjustment, cost–adjusted price indexes are problematic for businesses with high and variable gross margins. Although published price indexes are readily available, it’s not possible for companies to predict the actual yearend Lifo expense without knowing the actual cost complement adjustment. SIMPLIFIED LIFO CALCULATIONS WILL BECOME EASIER and more predictable now that companies can use price indexes directly. As a result CPAs can recommend that employers and clients adopt the IPIC method with confidence they can realize the administrative and computational benefits without unnecessary variations.

BRUCE HOWARD, CPA, PhD, is professor of accounting and chair of the department of business and economics at Wheaton College in Wheaton, Illinois. He also maintains a private accounting practice. His e-mail address is bruce.howard@wheaton.edu .

here’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.

A MIXED BLESSING

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 traditionally 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.

CHOICES, CHOICES

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. Instead of having to maintain base year cost records or invest resources in developing their own cost indexes, taxpayers could use the BLS’s monthly price indexes. But they then had to convert the relevant price index into a company-specific cost index by using their own gross margin experience to develop the cost complement (1 minus gross margin percentage) of the published index. Small businesses (those with average annual gross receipts of $5 million or less for the three preceding tax years) are allowed to use 100% of the reported price change. All others are restricted to using 80% of the reported change. For some, these restrictions are a small price to pay for the relative ease and certainty of using a reported index.

THE PREDICTABLE SIDE OF SIMPLIFIED LIFO

A distinct advantage of simplified Lifo is it can produce a highly predictable Lifo adjustment, avoiding troublesome yearend surprises. Higher predictability also enhances quarterly financial reporting and promotes greater precision in making estimated tax deposits. Because the BLS reports the price indexes monthly (generally within three weeks of month end) CPAs can keep an eye on inflation’s impact on Lifo throughout the year. CPAs can easily access the indexes via the Internet at www.bls.gov/ .

When a business uses simplified Lifo, the Lifo effect and subsequent adjustment is merely the allowable percentage change in the index multiplied by the Fifo value of the prior year’s ending inventory. Exhibit 1 illustrates this for both small and large companies using the old rules that require a cost complement adjustment. If the cost adjusted index shows 10% inflation, then the Lifo adjustment is 10% of the Fifo value of the prior year’s ending inventory. Exhibit 1 assumes an annual inflation rate of 10%, a constant cost complement percentage of 60% (1 minus gross margin percentage of 40%) and no real increase in the physical amount of the inventory.

For the small company example in exhibit 1 the Lifo adjustment in year 20X2 is $1,000—10% of year 20X1’s $10,000 ending inventory Fifo value. The adjustment in year 20X3 is $1,100—10% of year 20X2’s ending inventory Fifo value. The same relationship can be seen in exhibit 1 ’s large company example. Even though inventory did not really increase, the same facts produced an increment for the large company (limited to using 80% of the inflation adjustment) and no increment for the small company. In either situation, using simplified Lifo produces a Lifo adjustment equal to the annual allowable inflation in the cost index times the prior year’s ending Fifo inventory value. This will be true whenever inventories are constant or show an increment. (It will not necessarily be true if they decrease.)

THE PROBLEM OF COST COMPLEMENT ADJUSTMENTS

So far, we have only considered changes in the price index, with gross margin and cost complement percentages treated as constants. But any change in a company’s gross profit percentage from year to year will have an impact on the size of the Lifo expense when the price index is adjusted to a cost complement index. A decrease in gross profit percentage will result in a greater measure of inflation and produce a larger Lifo adjustment than if the gross margin had remained the same as the previous year. The converse would be true of an increase in the gross profit percentage because the larger gross profit, when backed out of the price index, would result in a smaller cost index and consequently less inflation.

Adjusting price indexes to cost indexes works best for companies engaged in activities such as wholesaling, which typically experience high volume and consistently low gross margins. But cost-adjusted price index methods are problematic for businesses with high and variable gross margins. These companies typically have heavy fixed costs associated with inventory and thus experience significant variations in average unit costs arising from swings in production volume. This makes it difficult to calculate an accurate gross margin percentage on an interim basis. The company does not know the true gross margin for the year until it takes a physical inventory in conjunction with a timely and accurate sales and accounts payable cutoff.

Even though the relevant published price index is readily available, predicting the actual yearend Lifo expense is still not possible without knowing the actual cost complement adjustment. Thus any predictive benefit from regularly published price indexes is lost. But more important, for taxpayers with typically high margins, relatively small swings in the gross margin percentage can greatly distort the reported Lifo expense calculation when a price index must be adjusted to its cost complement.

Exhibit 2 uses the old rules and compares a company with high margins to one with relatively low margins to show how a similar three-point swing in a gross profit margin produces very different Lifo adjustments. The price index is assumed to be constant over the three years to highlight the impact of the changing cost complement percentage.

When the high margin company experiences a three-point dip in its gross margin percentage, resulting in a corresponding three-point increase in its cost compliment, the dip produces a Lifo expense adjustment of $750 (7.5% of inventory) even though the price index did not change. But for the low margin company, the impact of a similar three-point change in margins only produced a Lifo expense adjustment of $375 (3.8%) of inventory. In the following year, the margins are assumed to revert back to where they were at the outset. The high margin company shows over twice as much income created by the Lifo adjustment as does the low margin company. These year-to-year swings in the Lifo adjustment are generally unwelcome. Keeping a watchful eye on the monthly price index would most likely have lulled a taxpayer into thinking there would be no Lifo effect at all because there was no visible sign of either inflation or deflation. But if there was a resulting change in gross profit margins, taxpayers could have quite a surprise on their hands. As exhibit 2 shows, the surprise could go either way, and would affect high margin companies more than low margin companies.

A SIMPLER CALCULATION

Lifo calculations using published price indexes become easier and more predictable when CPAs can use price indexes directly. Exhibit 3 , shows how to calculate the Lifo adjustment without having to resort to an adjusted cost index. The example illustrates a small company experiencing 10% annual inflation in selling prices and increasing levels of inventory in the second and third years.

Note that the yearend Lifo adjustment equals the annual inflation rate (10%) times the beginning Fifo value of the inventory. This will be the case whenever a company experiences an increase in inventory. As a result, the annual Lifo adjustment becomes quite predictable.

AN END TO VOLATILITY

The proposed changes in IRS Bulletin 2000-23 eliminate the required cost complement adjustment and bring welcome simplification to the IPIC method of accounting for inventory on a Lifo basis. This enhances the taxpayers’ ability to predict the yearend Lifo adjustment. More important, the simplification eliminates the unwelcome volatility in Lifo expense created when high margin businesses experience even slight changes in gross margin percentages. CPAs can recommend employers and clients adopt the IPIC method with confidence that it will result in a more highly predictable outcome and greatly reduce the administrative and computational burdens of traditional double extension and link-chain Lifo.