Base-year updates can improve quality of LIFO calculations, yet are hard to come by.

• Author: Staley, Dan
• Position: Last-in, first-out

Many taxpayers continue to use the last-in, first-out (LIFO) method of accounting to determine the cost of their inventory. This method of accounting assumes that the goods most recently purchased or produced are the first goods sold and, accordingly, that their associated costs are the first costs treated as costs of sale, Thus, inventory basis is built up in layers over time as ending inventories periodically increase over beginning inventories. The accounting theory supporting LIFO is the belief that it provides a better matching of current costs with current revenues, thereby eliminating inventory profits from the taxpayer's earnings. In this way, businesses are able to reinvest their profits in inventory in an economically efficient manner.

Dollar-Value LIFO

Most LIFO taxpayers employ the dollar-value method as their overall LIFO method (as opposed to the specific-goods LIFO method). Unlike the specific-goods method (which measures inventory increases or decreases based solely on quantity changes of specific items), the dollar-value method measures inventory increases and decreases using base-year dollars as the unit of quantity measure, Under dollar-value LIFO, a number of related inventory items are grouped into a pool. Whether inventory of the pool increased or decreased for the tax year is based on the aggregate change in base-year dollars of all of the items within the pool, Indeed, the proper measurement of whether inventory increased or decreased from the beginning of the year is critical to clearly reflect income under the dollar-value method.

At the center of a dollar-value LIFO calculation using the double extension method is the requirement that all items in ending inventory be revalued at their respective base-year costs. A base-year cost represents an item's costs that were or would have been in effect at the beginning of the base year, which generally is the year LIFO was adopted. Each year-end, the taxpayer's inventory valued using base-year costs must be compared to its prior year-end inventory valued using the same base-year costs, in order to determine whether the taxpayer experienced a true increase (increment) or decrease (decrement) of inventory within the pool.

An increment is then revalued to its current cost, and constitutes a new layer added to the carrying value of the taxpayer's inventory. Decrements are subtracted from the built-up inventory history in reverse chronological order. As might be expected, it is...