Voluntary LIFO method change can forestall IRS challenge.

• Author: Garrett, Richard W.
• Position: Last-in-first-out accounting method

Over the last few years, the IRS Industry Specialization Program (ISP) has identified certain LIFO inventory methods that it believes are improper. Companies using a LIFO method that the Service believes is erroneous should consider voluntarily changing to a method it will accept, thereby precluding the IRS from raising the issue for earlier years.

Estimating Earliest Acquisitions Cost

A company must determine the current-year method that it will use to value its LIFO increments (i.e., LIFO layers). The most common methods are the earliest acquisitions, the latest acquisitions and the average cost of acquisitions methods.

Because the earliest acquisitions method is not used for internal management purposes, many LIFO companies have developed shortcuts for estimating earliest acquisitions cost. One common shortcut for companies using the link-chain method is a dual-index method that eliminates the need to compute earliest acquisitions cost, unless there is a current-year increment.

Under a dual-index method, a cumulative deflator index is computed, employing year-end FIFO costs, and then is used to determine base-year cost. If an increment occurs, a cumulative inflator index is used to state the increment at its current-year earliest acquisitions cost. The inflator index is computed by extending the current year's ending inventory at its current year's earliest acquisitions cost and its prior year's FIFO cost; see Exhibit 1, on page 461.

A taxpayer must compute the current year's inflator index based on actual earliest acquisitions cost (see Example 1).The following methods are not acceptable: (1) use of the prior year's cumulative deflator index to value the current year's increment, assuming there is no inflation at the beginning of the current year or (2) use of a method that estimates the earliest acquisitions cost based on inventory turns.

Example 1: Company A computed the base-year cost of its 1998 increment as follows:

FIFO value of 12/31/98 inventory $208,000 1997 cumulative deflator index 2.00 1998 deflator index x 1.04 1998 cumulative deflator index / 2.08 Base-year cost of 1998 inventory $200,000 Base-year cost of 1997 inventory - $150,000 Base-year cost of 1998 increment $50,000 A's inventory turned over four times in 1998. Using an inventory-turnover method to compute its yearly inflator index, A showed 1% inflation for the year: 1998 deflator index inflation 4%/1998 inventory turns 4 = 1% 1998 inflator index inflation Using the...