A client that uses last-in, first-out inventory for tax lowers taxable income when prices rise. The price of that benefit is the conformity rule: the client cannot use a different inventory method to report income to shareholders, partners or creditors. A bank covenant package built on FIFO income, or an investor deck showing FIFO earnings as the primary result, can put the LIFO election at risk. The CPA firm that prepares financial statements for a LIFO client needs to know where the line is.
The statute
Section 472(a) allows a taxpayer to use the LIFO method in inventorying goods specified in an application filed in the time and manner the Secretary prescribes, under regulations. Section 472(c) conditions the election: it applies only if the taxpayer establishes to the satisfaction of the Secretary that it used no procedure other than LIFO (under paragraphs (1) and (3) of subsection (b)) in inventorying the goods to ascertain income, profit or loss for the first year, for the purpose of a report or statement covering that year to shareholders, partners or other proprietors or beneficiaries, or for credit purposes.
Treas. Reg. 1.472-2(e) carries that condition forward. The taxpayer must establish that, for the first LIFO year and any subsequent year, it has not used any inventory method other than LIFO in ascertaining income, profit or loss for credit purposes or for reports to shareholders, partners, other proprietors or beneficiaries.
What the regulation does not treat as a violation
The regulation lists uses of non-LIFO methods that are not at variance with the requirement, including:
- Supplemental information. Using another method to produce information reported as a supplement to or explanation of the primary presentation of income, profit or loss in credit statements or financial reports, including preliminary and unaudited financial reports.
- Balance sheet values. Using another method to determine the value of inventory on hand for reporting inventories as assets. A LIFO client can therefore show inventory at FIFO or current cost on the balance sheet if the rules in paragraph (e)(4) are followed.
- Internal management reports.
- Interim reports covering less than the whole taxable year for which LIFO is used.
- Lower of LIFO cost or market in certain circumstances.
Each of these has conditions in the regulation. For supplemental information, paragraph (e)(3) says that non-LIFO information on the face of the financial income statement is not considered a supplement or explanation. Information in notes to the income statement, or in an appendix or supplement that accompanies the income statement in a single report, can be. Paragraph (e)(4) adds that a balance sheet may show inventory on a non-LIFO basis, but any non-LIFO income effect can appear only in a footnote, a parenthetical, or a clearly labeled supplemental balance sheet. Read paragraph (e) before approving a lender package.
The election and the dollar-value method
Under Treas. Reg. 1.472-3, the election is filed with the income tax return for the first year LIFO is used, on Form 970 or in another manner the Commissioner accepts. The statement includes an analysis of inventories at the beginning and end of the first LIFO year and at the beginning of the prior year. Under Treas. Reg. 1.472-8, the dollar-value method measures inventory in total dollars rather than specific goods, grouped in pools. Base-year cost is the aggregate cost of the pool's items at the base date, the start of the first LIFO year. Increments and liquidations are measured as a net change for the pool, and each increment forms a separate layer. The usual way to value an increment is the double-extension method: the increment is multiplied by the ratio of total current-year cost to total base-year cost.
Worked example
A distributor's pool has a base-year cost of $2,000,000 at the beginning of the LIFO year. At year end, inventory at current-year cost is $2,310,000, and the price index for the pool is 1.10.
- Ending inventory at base-year prices: $2,310,000 divided by 1.10, or $2,100,000.
- Increment in base-year dollars: $2,100,000 minus $2,000,000, or $100,000.
- Increment layer at current-year cost: $100,000 times 1.10, or $110,000.
- LIFO ending inventory: $2,000,000 base layer plus $110,000, or $2,110,000.
- LIFO reserve: $2,310,000 minus $2,110,000, or $200,000.
The $200,000 reserve is the amount by which LIFO taxable income is lower, cumulatively, than it would be using current cost. A bank covenant defined on FIFO EBITDA would add back the change in the reserve. The compliance certificate should present LIFO income as primary and put the reserve change in a supplement or note that accompanies the statements. The inventory costing rules from the book side are in ASC 330 FIFO, average and LIFO.
Worked example: a layer liquidation
Next year the same pool ends at $1,950,000 stated at base-year prices, $150,000 below the prior year's $2,100,000.
- A liquidation reduces the most recent layer first. The $100,000 base-year layer, carried at $110,000, is eliminated.
- The remaining $50,000 comes out of the base layer, which is carried at base-year cost.
- LIFO ending inventory: $1,950,000, down from $2,110,000, a $160,000 decrease.
- That $160,000 of old, low-cost inventory flows into cost of goods sold instead of current-year purchases, so taxable income is higher by the gap between old cost and current replacement cost.
The client sees the effect as income with no matching cash. Run the pool computation before year end, while purchases can still restore the quantity.
Common errors
- Showing FIFO net income on the face of the financial income statement. Paragraph (e)(3) says information on the face is not a supplement.
- Letting a lender's agreement define net income on a FIFO basis and then preparing the certificate to match.
- Treating an interim report as free of the rule. A series of interim reports is treated as one report if it uses a single method.
- Ignoring related entities. Under section 472(g), financially related corporations are treated as one taxpayer for the conformity rule.
- Forgetting the consequence. Section 472(e)(2) lets the Secretary require a change from LIFO when a later year uses another procedure for owner or credit reporting.
Engagement checklist
- Confirm which clients use LIFO for tax and obtain the Form 970 or the accepted election.
- Read credit agreements for definitions of net income and EBITDA that require another inventory method.
- Review the covenant certificate, management reports and any investor materials for primary-presentation changes.
- Track the LIFO reserve and layer liquidations. A liquidation of a prior-year layer raises taxable income.
- Coordinate the book and tax method so that conformity is maintained when the client changes lenders. See bank covenants and the CPA firm's role.
Sources
- Legal Information Institute, 26 U.S.C. 472, Last-in, first-out inventories: https://www.law.cornell.edu/uscode/text/26/472
- Legal Information Institute, 26 CFR 1.472-2, Requirements incident to adoption and use of LIFO inventory method: https://www.law.cornell.edu/cfr/text/26/1.472-2
- Legal Information Institute, 26 CFR 1.472-3, Election of LIFO inventory method: https://www.law.cornell.edu/cfr/text/26/1.472-3
- Legal Information Institute, 26 CFR 1.472-8, Dollar-value method of pricing LIFO inventories: https://www.law.cornell.edu/cfr/text/26/1.472-8
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