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New Vehicle Dealership Audit Technique Guide - 2004 - Chapter 5 - LIFO (12-2004)

NOTE: This guide is current through the publication date.  Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to return to either the previous chapter or the Table of Contents or to proceed to the next chapter.

Chapter 4 | Table of Contents | Chapter 6

Chapter 5 - Table of Contents

Introduction
LIFO Concepts
Pooling
LIFO Election
LIFO Computations

Introduction
The information that follows concerns dollar value LIFO computations using the conventional definition of an item, including full comparability of items. This section also applies to an auto dealership that was eligible to elect 97-36 and did not exercise that election. A separate section discussing "Alternative LIFO," as defined in Rev. Procs. 92-79, 97-36 and 2001-23 is found later in this ATG.

This information focuses on the application of LIFO to new vehicles in ending inventory. The application of LIFO to used cars and parts is similar.

The information that follows is an attempt to explain the basic concepts of LIFO. This compendium not only addresses the technical principles to apply, but provides an in-depth case study featuring precise computations and definitions of what is being computed. It is our wish to make the revenue agent comfortable with these concepts so they will have the necessary confidence to complete this issue that may arise during an auto dealership examination.

LIFO Concepts
This section is arranged in a question and answer format addressing issues most often encountered in this area.

  1. Why do we need to compute LIFO indices?
    We need to compute LIFO indices to determine the annual reserve increment (or decrement) known as the LIFO layer. This amount is added to or subtracted from the reserve on an annual basis. The LIFO reserve is the difference between the LIFO valuation of ending inventory and its non-LIFO (i.e. first-in, first-out, specific identification or average cost) valuation. By computing the annual index we can determine this inflationary rate, which is added to the non-LIFO value. The result of inflation being added to ending inventory creates the layer that adds to the reserve balance and increases the current year cost of goods sold deduction. The reserve balance creates a tax deferral for the dealership.

  2. How do we measure the value of LIFO inventories?
    There are two methods: the Unit Method (also known as the Specific Goods Method) and the Dollar Value Method.

The unit method is used where an inventory consists of specific items or goods that may be considered fungible. This method measures inventory changes in quantity of items. The unit method is rarely used by the auto dealership industry. The dollar value method measures inventory changes in terms of dollars instead of in terms of changes in quantity of items. This method is properly used when measuring an inventory that contains similar specific items such as vehicles. This method groups items into separate pools. See Treas. Reg. section 1.472-8. Most auto dealerships use the dollar value method.

  1. What are the Dollar Value methods of pricing a LIFO inventory?
    Treas. Reg. section 1.472-8(e)(1) states there are four:

    • Double Extension Method

    • Link Chain Method

    • Index Method

    • Retail Method (not discussed at this time)

Whatever method is used must consistently and clearly reflect the income of the taxpayer. See IRC section 446(b). The dollar value method of valuing LIFO inventories is a method of determining cost by using "base year" cost expressed in terms of total dollars rather than quantity and price of specific goods as a unit of measurement. See Treas. Reg. section 1.472-8.

This Guide will primarily focus on the Link Chain Method and touch upon the Double Extension Method because these methods are more commonly elected by auto dealers to value their inventories. The index method has not been encountered in an auto dealership setting, but is mentioned because it is an acceptable method that may be used. The retail method is technically an acceptable method to use, but it would be unlikely to be encountered because it uses external indexes that may produce indices significantly lower than those the auto dealer can generate internally.

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a.        Double Extension Method

Under the double extension method, the quantity of each item in the inventory pool at the close of the taxable year is extended (priced) at both base year unit cost and current year unit cost. (Pools are discussed below.) The respective extensions (pricing) of the two costs are each totaled. The first total gives the amount of such inventory in terms of current year costs. (See below, for a discussion of determining current year costs). The second total gives the amount of such inventory expressed in base year costs.

Under the double extension method, a base year cost must be ascertained for each item entering a pool for the first time subsequent to the beginning of the base year. In such a case, the base year unit cost of the entering item shall be the current year cost of that item, unless the taxpayer is able to reconstruct or otherwise establish a different cost.

The double extension index formula is as follows:

                Current year quantity (CYQ) x Current year costs (CYC)
Index = —————————————————————
                Current year quantity (CYQ) x Base year costs (BYC)

b.        Link Chain Method

The link chain method is a cumulative index that considers all annual indices dating back to the year of election. It is used to restate current year inventory to base year costs. This cumulative index is also used to value increments of base
year cost when they occur.

This cumulative index is called the link chain method because it is derived by a multiplication process that involves the "linking" of annual indices back to base year. For example, if the year of the LIFO election is 1991, and the current year is 1993, the 1993 link chain index is computed as follows:

1991 index times 1992 index times 1993 index = 1993 cumulative link chain index.

c.        Index Method

Under the index method, indices are developed by double extending a representative portion of inventory in a LIFO pool or by using other sound and consistent statistical methods. The formula for calculating the sample index is identical to the one used in the double extension method. 

In order to determine total base year costs, total current year cost is divided by a weighted average index derived for the sample. This calculation technique is necessary because the index method does not double extend the entire current year inventory. This index is also used to value increments. 

The dollar value indices determined under the double extension and index methods measure inflation from "day 1" of the LIFO election, through the current year.

The annual inflation index is determined according to this formula:

                End of year quantity (EQ) x End of year costs (EC)
Index = ——————————————————————
                End of year quantity (EQ) x Beginning of year cost (BC)

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  1. How does reconstruction of base year costs affect Dollar Value pricing?
    The double extension method is the "preferred method" to compute base year costs as stated in Treas. Reg. section 1.472-8(e)(1). However, in the auto dealership context, using the double extension method to reconstruct base year costs raises concerns and hence is more susceptible to error than other known methods.

LIFO - Reconstruction of New Item Cost
Treas. Reg. section 1.472-8(e)(2) states in part; "Double-extension method.  —(i) Under the double-extension method the quantity of each item in the inventory pool at the close of the taxable year is extended at both base-year unit cost and current-year unit cost (emphasis added)." 

Under the double-extension method a base-year unit cost must be ascertained for new items entering a pool for the first time. The base-year unit cost of the new item shall be the current-year cost of that item unless the taxpayer is able to reconstruct or otherwise establish a different cost.  

If the new item is a product or raw material not in existence on the base date, its cost may be reconstructed, that is, the taxpayer using reasonable means may determine what the cost of the item would have been had it been in existence in the base-year. If the item was in existence on the base date but not stocked by the taxpayer, he or she may establish, by using available data or records, what the cost of the item would have been to the taxpayer had he or she stocked the item.

If the base-year unit cost of the entering item is either reconstructed or otherwise established to the satisfaction of the Commissioner, such cost may be used as the base-year unit cost in applying the double-extension method.  If the taxpayer does not reconstruct or establish to the satisfaction of the Commissioner a base-year unit cost, but does reconstruct or establish to the satisfaction of the Commissioner the cost of the item at some year subsequent to the base-year, he or she may use the earliest cost which he or she does reconstruct or establish as the base-year unit cost.

It is clear from the language used in the regulations that this issue is highly factual. The regulations state the taxpayer "using reasonable means may determine what the cost of an item would have been had it been in existence in the base year."

The regulations place the burden of reconstruction on the taxpayer by creating a presumption that base-year cost equals current-year cost for new items unless the taxpayer can demonstrate otherwise. This burden should not be taken lightly. The Supreme Court, in Burnet v. Houston, 283 U.S. 223 (1931) stated, "The impossibility of proving a material fact upon which the right to relief depends, simply leaves the claimant upon whom the burden rests with an unenforceable claim, a misfortune to be borne by him, as it must be borne in other cases, as the result of a failure of proof."

A number of techniques have been developed to make reconstruction easier. One technique is to elect the link-chain method. This method, which has generally been permitted, substantially reduces the task of reconstruction. This is so, because reconstructed costs only have to be established as of the beginning of the current year and generally there will be fewer completely new items.

Another technique used is to broadly define the inventory item. If a car dealer treats all cars as one item, there would probably never be a new item in the car pool.

The technique probably used most often is to develop an index for comparable items and then use that index to determine the base-year cost (beginning of the year cost for a link-chain taxpayer) for new items. Whether or not this reconstruction technique is reasonable has been the subject of two recent private letter rulings.

Chief Counsel recently commented on retail automobile dealerships with essentially the same facts and arguments. Each dealership had reconstructed the beginning-of-the-year costs of new vehicles in ending inventory utilizing an index derived only from comparable vehicles. The dealers argued they had used a reasonable method of reconstruction because the cost increases for comparable vehicles should be used as a guide for the new vehicles. They stated that it would be reasonable to assume that non-comparables (new vehicles) would have increased in price at the same rate as other vehicles produced by that same manufacturer. The same administrative staff, raw material suppliers, union contracts, and depreciation schedules, etc., would influence the price of both comparables and non-comparables. One dealer argued that a new vehicle as a percentage of the total inventory was not material and therefore, it had double-extended a representative portion of its inventory. The facts showed that comparable vehicles represented anywhere from 73 to 100 percent of the value of the vehicles in the various pools and years.

The National Office defines "comparables" as items that exist in both beginning and ending inventory. Non-comparables are items that only exist in the ending inventory.

The National Office concluded that the reconstruction methods used by these dealers were not reasonable and provided the following reasons:

  1. Comparable and non-comparable vehicles may vary in their characteristics and costs.

  2. This method is not supported by the regulations. It is inappropriate to apply an index derived from one subset of items in a pool to another subset of items. An index computed that excludes new models does not clearly reflect income.

  3. The method has the potential to produce distortions in the dollar-value computations. These inaccuracies would then cause distortions in computations in subsequent years due to the use of the link-chain method.

  4. Even if a dealer could substantiate its claim that the effect of inflation on comparable vehicles is reflective of the effect on non-comparable vehicles, there is no reasonable assurance that this relationship would continue in the future.

  5. A price index for a dollar-value LIFO pool must be computed based on all the items in ending inventory for that pool.

The National Office stated, "Whether a taxpayer's particular method is reasonable is a determination that should be left to the district director because such a determination requires a facts-and-circumstances analysis [emphasis added]."

In a PLR the National Office stated "A taxpayer's method of reconstruction should be considered reasonable if the taxpayer can demonstrate that the method used is an accurate measure of what the rate of inflation would have been had the new item been in existence in the prior year, or had the item been stocked by the taxpayer in the prior year. For example, had X used an index derived from a portion of its vehicles in ending inventory that X could demonstrate were comparable to a particular new model, application of that index to derive a reconstructed beginning-of-the-year cost for that new model should be acceptable."

If the taxpayer's method of reconstruction is an issue, develop the issue by first determining how the taxpayer computes its index for new items. Consider following these steps;

  1. Interview the individual(s) who did the LIFO computations and ask them how they handled new items. If the method used does not appear to be reasonable you need more information.

  2. Submit an Information Document Request for either a list of the new items or an identification of the new items on the double-extension schedules or inventory records.

  3. Request the taxpayer to identify new items that existed in the base year (beginning of the year for a link-chain method) but were not stocked. Start with the tax years under examination.

  4. If items existed but not stocked, the taxpayer should be able to obtain a proper cost either from existing price sheets or from its suppliers. Ask the taxpayer to obtain the cost prices.

  5. Give the taxpayer the opportunity to demonstrate that the index derived for an existing item is comparable to a particular new item.

  6. For the remaining items that are completely new, ask the taxpayer to either reconstruct the cost using reasonable means or accept the current price as the base or beginning-of-the-year price.

  7. Depending on the results of the revised computations for the current year(s) under examination, consider either applying the steps above to prior years or adjusting the prior years using error rates for the current year(s).

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Keep in mind that the regulations place the burden of reconstruction squarely upon the taxpayer. It is not the examiner's responsibility to either do the reconstruction or even to do a statistical sample to establish whether or not the taxpayer's short cut method is accurate and reliable. The examiner only has to demonstrate with supporting workpapers using the taxpayer's records (double-extension schedules and inventory listings) that the comparable (existing items) and non-comparable items vary in their characteristics and cost.

Since this is a facts-and-circumstances issue and the taxpayer is allowed to use reasonable means to reconstruct, the examiner should make every effort to resolve this type of issue.

Another issue that has come up in this area is whether a taxpayer may retroactively reconstruct the cost of a new item where the current year cost was used for that item as the base-year cost when the returns were filed. In the particular case where this issue arose, the taxpayer proposed this and requested a large refund during the examination.  How an item is valued would appear to be a method of accounting and any change in how that item is valued would be a change in method of accounting. Treas. Reg. section 1.446-1(e)(2)(ii)(a) states in part, "* * * Changes in method of accounting include * * * a change involving the method or basis used in the valuation of inventories * * *."

A taxpayer in the business of manufacturing diamond rings reconstructed the base-year cost of new diamonds by comparing them to a higher quality diamond. The Service held that the correction of the base-year cost of an item constitutes a change in method of accounting that could only be done prospectively. See IRC section 446 and the corresponding regulations, Hamilton Industry, Inc., Successor of Mayline Company, Inc. and Subsidiary v. Commissioner, 97 T.C. 120 (1991) and Rev. Rul. 90-38, 1990-1 C.B. 57. 

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  1. For Dollar Value LIFO what is the definition of an item?
    The next few paragraphs reference the Motor Vehicles Industry Specialization Program's coordinated issue paper "Dollar Value LIFO – Definition of an Item". For more detail please refer to the full text.

An item of inventory is defined, for purposes of calculating the value of the taxpayer's inventory under the dollar-value LIFO method as authorized by Treas. Reg. section 1.472-8, is defined by reference to a particular vehicle as to make, year, model, body style, standard equipment, options, and other factors.

Treas. Reg. section 1.472-8(e)(2)(i) provides that under the double-extension method, the quantity of each item in the inventory pool at the close of the taxable year is extended at both base-year unit cost and current-year unit cost. Under the link-chain method, the quantity of each item in the inventory pool at the close of the taxable year is extended at both the beginning-of-the year unit cost and the end-of-the-year unit cost. Neither the Code nor the regulations define what constitutes an item.

The tax court in Wendle Ford Sales, Inc. v. Commissioner, 72 T.C. 447(1979), determined that 1975 Fords with solid-state ignitions and catalytic converters were not new items when compared to 1974 Fords that did not have solid-state ignitions and catalytic converters. The manufacturer determined whether or not a Ford had either of these features. Their cost was never separately stated on the dealer's invoice. The court decided that the entire car was the item and not the individual components or parts. 

Vehicles on hand at the end of 2 different taxable year should be compared considering differences in make, year, model, body style, standard equipment, options, and other factors, appropriate adjustments should be made to the cost of the vehicles on hand at the end of the prior taxable year to account for as many of these factors as possible. The prices of all factory installed options are readily available to distributors and dealers. For body style, standard equipment, options and other features that are available at one point and not another, the adjustment should be based on the stated or implied price when available and factored in as a percentage of the base vehicle cost.

Under full comparability LIFO when a vehicle cannot be compared to a similarly equipped vehicle in the prior year, beginning and ending cost are the same, resulting in an index of 1.00.

Reconstruction is a fundamental issue for all three methods. The base year cost of an item will be the current year cost of the item unless the taxpayer is able to reconstruct or otherwise establish a different cost to the satisfaction of the agent.

If the taxpayer originally elects on their Form 970 the double extension method, but applies the link chain method without requesting permission, the taxpayer has an unauthorized change in accounting method. The taxpayer should recalculate their LIFO by applying the double extension method as originally filed. If the taxpayer wishes to change their method, then a Form 3115 should be filed under the provisions of Rev. Proc. 97-27, 1997-1 C.B 680 (May 8, 1997).

  1. How many ways are there to compute a dollar value index?
    There are two general classes of indices, the internal and the external. The internal method generates indexes from information derived and maintained by the dealership. The external method indices are taken from the Consumer Price Index (CPI) or the Producer Price Index (PPI).

These classes of indices should not be confused with different LIFO methods previously discussed. Remember, an index is a subpart of an overall LIFO method tracking the inflation or deflation of a particular item (pool) in ending inventory at a certain yearend.

The external indices are used with the Inventory Price Index (IPI) Method and are seldom used for two reasons. The Government generated indices are generally lower than those produced internally by the dealers. Second, a dealership or group with gross receipts over $5,000,000 does not qualify, under IRC section 474, and under the IPI method can only take 80 percent (100% after for tax years ending after 12/31/2001 per Treas. Reg. 1.472-8) of the annual change in IPI Method CPI or PPI for the index. The use of the external indices is an election made with the adoption of LIFO or if this represents a change in method, then a Form 3115 should be filed under the provisions of Rev. Proc. 97-27, 1997-1 C.B. 680 (May 8, 1997).

  1. What methods can be used to determine the current-year costs that can be used in the index calculations to price units in the yearend inventory?
    The current-year costs that can be used in the index calculations are:

  1. Cost based on the most recent purchases.

  2. Cost based on the average cost of purchases during the year.

  3. Cost based on the earliest acquisitions during the year.

Remember, each item in the inventory pool at yearend is priced at current-year cost. See Treas. Reg. section 1.472-(2)(i).

In addition to these three methods, the regulations authorize the use of any other proper method that, in the opinion of the Commissioner clearly reflects income. Whatever method is adopted, it must be adhered to in all subsequent years. See Treas. Reg. section 1.472-8(e).

We will focus our concentration on the Earliest Acquisitions Method and the Latest Acquisitions Method (most recent purchases) because these are the most prevalent in the auto dealership industry.

The earliest acquisitions method encompasses pricing the inventory items on hand at the yearend with the actual cost of goods purchased during the taxable year in the order of acquisition. This theoretical position assumes that pricing is being done in chronological order to the actual purchases.

Note, in dollar-value LIFO, the indices are used to ascertain the amount of the LIFO reserve. However, in using the earliest acquisitions method, not only is the index creating the reserve, in addition there is an amount created called a "Hidden Reserve." If we compare the result of the pricing of yearend inventory using the earliest acquisitions method to the general ledger amount of the inventory at yearend, the difference is this additional amount of "reserve."  This difference is not obtained in using the most recent purchases method.

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An example of these comparisons follows:

Example 1
There are 40 units of X in ending inventory that are to be valued at their earliest acquisition cost. Purchases of X during the year were as follows:

Date Quantity Amount
1/21

10 @

$2.00

2/15

10 @

  2.10

3/25

15 @

  2.15

4/08

30 @

  2.25

5/10

100 @

2.30

10/11

150 @

2.50

12/10

 200 @

2.45

The current year cost of X computed according to the earliest acquisition
cost method would be $84.50:

10 x $2.00 = $20.00
10 x   2.10 =   21.00
15 x   2.15 =   32.25
05 x   2.25 =   11.25
40                  $84.50

In contrast the FIFO amount (cost) = 40 x 2.45 = $98.00

The difference between the current-year cost pricing of the inventory being $84.50 and the FIFO amount of $98 results in a difference of $13.50, which is the "Hidden Reserve" obtained in earliest acquisition without considering the indices. This is an example of the hidden reserve referred to earlier.

If we want to use the most recent purchases (latest acquisition), the current year pricing will equal the amount using the FIFO amount. Therefore, the hidden reserve is not present under this method. Forty units at $2.25 equals $98 which is equal to the FIFO amount.

If an inventory contains a large number of different items, such as with auto dealerships, the pricing procedure just described could involve quite a few calculations and most, if not all, taxpayers do not price all items in their inventory using the earliest acquisition method. For this reason, the theoretical method of pricing ending inventory quantities under LIFO is not used and the taxpayers who elect this method use a shortcut method to determine the earliest acquisition cost. The IRS has not approved any short cut method. See coordinated issue "Segment of Inventory Excluded from the Computation of the LIFO Index."

In practice, using example 1 above, some taxpayers apply the earliest acquisition method of pricing quantities by using the $2 purchase price on January 21 to price all 40 units of X in ending inventory. Current-year costs of X would, therefore, be $80 (40 x $2). Even under this shortcut method a hidden reserve would result in the amount of $18.

In periods of inflation, the earliest acquisition cost generally produces the lowest LIFO inventory value. Use of the latest acquisition cost usually results in the highest LIFO inventory value.

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Pooling
Introduction

One of the central points of LIFO valuation is the requirement to compare only like kind items. A unique aspect of the dollar value method is pooling, allowing the dealer to combine like kind items into a group where inflation is computed on these like kind items. If non-comparable items were pooled together there would be a fundamental problem with the indices causing a material distortion of income.

Assuming the dealership elects LIFO for its inventory, under the full comparability LIFO method, a dealer may have a pool for:

  • New cars

  • New trucks

  • Parts

  • Used cars

  • Used trucks

  • Other items such as recreational vehicles

Proper pooling must be determined for each trade or business. Some of the factors Chief Counsel has relied upon are based upon the particular facts and circumstances of the dealership include the following:

  1. The dealership is engaged in the same type of activities (i.e., those related to new and used vehicle sales and service).

  2. Employees including upper-level management, accounting personnel and administrative personnel can work at other locations, for example, the same employee is the general manager of multiple locations that sell automobiles and the used car manager manages all used vehicle sales for all locations and purchases all used vehicles that are not acquired through trade-in sales. 

  3. The dealership only has one checking account out of which all payrolls and other expenses are paid. The dealership has one line of credit that is secured by all inventories, regardless of location or manufacturer.

Importance of Pooling
The first and probably the most important problem involved in the dollar-value method is determining the character of the inventory items which may be grouped into a pool. Two pools are required, one for cars and one for trucks. The reason this question is so important is that the goods grouped in one pool are treated as fungible under the dollar-value method. Hence, inventory decreases in one item may be offset by increases in another item contained in the same pool.  Under the specific goods method, if you have a quantity increase in an item of inventory, that increase is valued at the cost prevailing for that item in the year of the increase, absolutely separate from any other item in the inventory. Each item retains its own unique history of cost.

Under the dollar-value method, quantity increases or decreases are determined looking at the pool as a whole with the unit of measure the dollar. Treas. Reg. section 1.472-8(a) states in part "* * * new items which properly fall within the pool may be added, and old items may disappear from the pool, all without necessarily effecting a change in the dollar value of the pool as a whole." If there is a quantity increase, in terms of dollars, that increase is valued at the cost prevailing for the year of the increase considering all of the items in the pool.  Under this concept, historical cost for items decreasing or disappearing can be substituted for the cost of items increasing in quantity or new items entering the pool. This is the major difference between the dollar-value method and the specific goods method. If the pooling requirements were such that a pool had to be established for each item in the inventory, the results under dollar-value would not be much different than under the specific goods method. The results would be more accurate in that historic costs attributable to items liquidated could not be substituted for other items.

The Tax Court in Fox Chevrolet, Inc. v. Commissioner, 76 T.C. 708 (1981) (a new car and truck dealer with one pool) stated where "* * * a pool of inventory is depleted because sales exceed purchases during the year, the LIFO reserve is invaded and older "historic" costs flow into costs of sales. It is self-evident that the greater number of pools the greater the likelihood of such a liquidation occurring. [Emphasis added]." In Fox Chevrolet the Service wanted a pool for each model line of new cars. The Court noted that model lines change very rapidly and consequently pools would be liquidated each time a model line was discontinued.

The Tax Court in Richardson Investments, Inc. and Subsidiaries (Formally known as Rich Ford Sales, Inc.), a New Mexico Corporation v. Commissioner, 76 T.C. 736 (1981) [a new car and truck dealer] stated "[the Service's] 24-pool method, [pools by model line], would, in substance, place petitioner on the specific goods LIFO method."

What is interesting in the Richardson Investment case are the reasons stated why a second pool was required for new trucks. The Court stated:

[t] he use of two pools would not, as a practical matter, prevent petitioner from employing the dollar-value method. * * *; the two-pool approach succeeds in matching revenues from truck sales with the costs of producing such trucks, and revenues from the sale of cars with the costs of producing such cars. In addition, petitioner's income, for income tax purposes, would be clearly reflected because of this matching of revenues and costs. Thus, the objections found with respect to [the Service's] 24-pool approach and petitioner's 1-pool approach are not applicable to a 2-pool approach. To the contrary, the fundamental purposes of the dollar-value method are enhanced.

Rules for pooling that apply to dealers:

Wholesalers, Retailers, etc.
Treas. Reg. section 1.472-8(c) provides the rules for establishing pools for wholesalers, retailers, jobbers and distributors. Basically they must pool by major lines, types, or classes of goods. In determining such groupings customary business classifications of the particular trade in which the taxpayer is engaged is an important consideration. The regulations mention department stores as an example of the customary business classification.

Cases on this part of the law have involved new car and truck dealers, two of which have been noted above. The Tax Court's reasoning in the Richardson Investments, Inc. case brings another factor into the determination of the proper number of pools under this section of the regulations. Near the end of its opinion, the Court stated:

The two-pool [one for new cars and one for new trucks] approach succeeds in matching revenues from truck sales with the costs of producing such trucks, and revenues from the sale of cars with the costs of producing such cars. In addition, petitioner's income, for income tax purposes, would be clearly reflected because of this matching of revenues and costs. Thus, the objections found with respect to [the Service's] 24-pool approach and petitioner's 1-pool approach are not applicable to a 2-pool approach. To the contrary, the fundamental purposes of the dollar-value method are enhanced. Therefore, notwithstanding our earlier determination that one pool for new cars and new trucks is the customary business classification, this factor is outweighed by the clear reflection of income obtained by utilizing two pools. [emphasis added] See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, (1979).

This passage illustrates why requiring pools for unlike items is appropriate where customary practices are not firmly established.

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Inventory Price Index (IPI) Method
Be aware that there are special pooling rules for taxpayers electing to use the Consumer Price Index (CPI) or the Producer Price Index (PPI) method provided for by Treas. Reg. section 1.472-8(e)(3). If the CPI tables are used, pools may be established based on the 11 general categories of consumer goods described in the CPI detailed report. If the PPI tables are used pools may be established based on the 15 general categories of producer goods described in Table 6 of the Producer Prices and Price Indexes. See Rev. Proc. 84-57, superceded by TD 8975, for additional explanations of the pooling requirements for taxpayers who use this method.

Under this method a new car and new truck dealer could have one pool that would include both new cars and new trucks. "Transportation Equipment" is one of the 15 categories. However, not all of a car dealer's inventory falls into this one pool. Car radios, car batteries, metal stampings, tires, and engine components are some examples of dealer inventory that are in another PPI pool. 

What constitutes a new item?
Another issue is that of a "new item." In Wendle Ford Sales, Inc. v. Commissioner, 72 T.C. 447 (1979), the judge alluded to perhaps classifying new vehicles as new items after a period of 5, 10, or 15 years. Auto dealers maintain that technological changes are frequent and revolutionary. A 1995 Ford Thunderbird does not even closely resemble a Thunderbird of the early sixties, for all practical purposes only the name remains the same. 

There was a television commercial comparing a 1965 Mustang to a 1995 Mustang. The theme of the commercial stated these cars have the same name, but everything else is new. Therefore, in lieu of everything else, most new vehicle inventory should be reclassified as new items periodically. This reclassification assumes that dealers will not be able to reconstruct the base period cost of the items. This issue would be applicable no matter what LIFO method is used.

Reconstruction is available under both the double extension and link chain methods. For the double extension method, the reconstruction would be for a period from the current year back to the base year. The base year is the year of election. For the link chain method, the period would be from the current year to
the prior year only.

The calculation of the current inflation is derived from comparisons within each pool. For the double extension and the index method, the current inflation is derived by dividing the Base Year Cost into the Current Cost and subtracting the cumulative index for the prior year. As for the link chain method the current
inflation is derived by taking the Current Cost and dividing by the Beginning of Year Cost.

For a further discussion of the definition of an item, refer to the coordinated issue paper "Dollar Value LIFO-Definition of an Item".

Foundation Principles
IRC section 472(a), in substance, authorizes a taxpayer to elect the LIFO method, provided the method clearly reflects income. A method clearly reflects income only if the method conforms to the regulations prescribed by the Secretary of the Treasury. The LIFO regulations are legislative and carry the full force of law.

To further enhance our understanding, it would be useful to provide a general background of how the LIFO rules are arranged in the regulations. There are eight applicable subparagraphs:

Treas. Reg. section 1.472-1, authorizes the use of the LIFO method and provides general rules for the use of the specific goods method.

Treas. Reg. section 1.472-2, sets forth the requirements incident to the adoption and use of LIFO. A taxpayer adopting LIFO must file an application and specify with "particularity" the goods to which LIFO is to apply. The cost of goods in ending inventories over those in beginning inventories must be valued at a cost that is, at the option of the taxpayer, the most recent, average, or latest acquisition cost. Inventories valued at LIFO must be reported in the same manner for financial purposes. This last rule is frequently referred to as the "conformity requirement."

Treas. Reg. section 1.472-3 provides instructions on the time and manner of making the election. A taxpayer must attach a completed Form 970 or equivalent statement to the tax return for the first year LIFO is adopted. Form 970 provides the Service with detailed information about the LIFO method adopted by the taxpayer. The regulation states that the taxpayer's application to use LIFO is subject to the Commissioner's approval upon examination of the taxpayer's tax return. Audit adjustments are subject to the appellate process.

Treas. Reg. section 1.472-4 states that the taxpayer in electing LIFO agrees to any audit adjustments that the Commissioner might require in order to have the taxpayer's LIFO method clearly reflect income.

Treas. Reg. section 1.472-5 stipulates that the LIFO election is irrevocable unless written permission is secured from the Commissioner.

Treas. Reg. section 1.472-6 provides the inventory methodology a taxpayer must use if permission is received to discontinue the use of LIFO or if the IRS terminates the LIFO election for failure to conform with the LIFO regulations.

Treas. Reg. section 1.472-7 provides cross-references for valuing LIFO inventories of an acquiring corporation. The language in this regulation is identical to the language in Treas. Reg. section 1.471-9. Both of these regulations state that IRC section 381(c)(5) and the regulations thereunder prescribe the rules for valuing inventories acquired in certain corporate reorganizations.

Treas. Reg. section 1.472-8 contains the rules for the use of the dollar value method. These rules are relegated to eight subparagraphs in the regulations.  Below is a summary of these eight subparagraphs:

  • Paragraph (a) provides for the election of dollar value LIFO and then explains the conceptual basis underlying the method.

  • Paragraph (b) contains the pooling rules for taxpayers engaged in manufacturing.

  • Paragraph (c) contains the pooling rules for retailers and wholesalers. 

  • Paragraph (d) reserves for the Commissioner the right to determine the appropriate number and composition of the dollar value pools.

  • Paragraph (e) describes and explains the various dollar value methods available to the taxpayer.

  • Paragraph (f) prescribes the rules for changing from another LIFO method to dollar value (i.e., from specific goods to dollar value).

  • Paragraph (g) sets forth the rules for combining or splitting up dollar value pools.

The LIFO Election
In adopting LIFO, an election must be made to use the method. Such election is not automatically granted. To make the election, the following must be done:

  1. Form 970, "Application to Use LIFO Method," or its equivalent must be completed, signed and attached to the return filed for the year of election. Its equivalent means that if the taxpayer does not file a Form 970, but attaches a schedule supplying all the necessary information, the taxpayer will be deemed to be in compliance.

  2. A 3-year inventory analysis must be made for any increase in inventory value. Restatement of any other inventory value being used to state actual cost must be disclosed.

  3. A statement describing computations and calculation of the index must be made. If electing the Index method, or the use of the Link Chain method is employed, an additional statement with justification must be submitted.

A taxpayer adopting the LIFO method is bound by the election. An amended return cannot be filed to revoke the election. Terminating or modifying the use of an elected LIFO method requires the advance approval of the Commissioner although some changes are automatic under Rev. Proc. 88-15, 1988-1 C.B. 683.   Form 3115 should be used to make such changes. A taxpayer terminating LIFO generally cannot re-elect the method for 5 taxable years following the termination. See Rev. Procs. 88-15, 1988-1 C.B. 683 (superceded by RP 97-37, RP 98-60, RP 99-49 and RP 2002-9) and 92-20, 1992-1 C.B. 685, section 9.03(1).

The adoption of LIFO on Form 970 is tentative and is subject to the Commissioner’s approval upon audit. See Treas. Reg. section 1.472-3(d). Furthermore, the taxpayer agrees to any adjustments the Commissioner may deem necessary in order to have the elected method clearly reflect income. See Treas. Reg. section 1.472-4.

The LIFO election requires adherence to "conformity requirements" by the taxpayer to maintain its viability which are discussed as follows:

  1. Situations that do not warrant termination, but which may cause problems. These situations usually contemplate problems such as computational errors or applications. If a taxpayer elects the double extension method, but applies the link chain method without filing a Form 3115, this does not constitute a termination. The LIFO computations must be recomputed from the time of the election under the double extension method as originally elected. 

There are two methods that a taxpayer can elect on the Form 970, the unit method and the dollar value method. If a taxpayer elects the dollar value method of computing LIFO and is using the unit method or visa versa, without filing a Form 3115, then the taxpayer should be placed on the elected method as reflected on Form 970 from the time of the election of LIFO. See Rev. Proc. 79-23, 1979-1 C.B. 564, 1979.

  1. What are the conformity requirements?
    IRC section 472(c) states a taxpayer on the LIFO method for tax purposes must also use the same method for financial reporting. The application of this section primarily concerns statements affecting a full year's operation, whether the same as the taxable year or any other 12 month period.

No violation occurs if the taxpayer issues non LIFO reports or credit statements covering a period of operations that is less than the whole of the taxable year and less than 12 months. 

If the interim report contains annual financial data, the report must be on LIFO basis. Where the taxpayer presented its fourth quarter report to its shareholders on a FIFO basis and also included its results of operation for the entire 12-month period on a FIFO basis, the Service may terminate the use of LIFO. The conformity requirement will not be considered violated as long as the series of interim reports, when combined, do not present operating results for the year on a non LIFO basis.

A franchised automobile dealer that elected the LIFO inventory method for federal income tax purposes violates the LIFO conformity requirement of IRC section 472(c) or (e)(2) by providing to the credit subsidiary of its franchisor (an automobile manufacturer) an income statement for the taxable year that fails to reflect the LIFO inventory method in the computation of net income.

IRC section 472(e) provides that a taxpayer electing to use the LIFO inventory method must continue to use the LIFO inventory method unless the taxpayer: (1) obtains the consent of the Commissioner to change to a different method; or (2) is required by the Commissioner to change to a different method because the taxpayer has used some inventory method other than LIFO to ascertain the income, profit, or loss of any subsequent taxable year in a report or statement covering that taxable year (a) to shareholders, partners, other proprietors, or beneficiaries, or (b) for credit purposes.

Section 1.472-2(e)(1) of the Income Tax Regulations provides that a taxpayer electing to use the LIFO inventory method must establish to the satisfaction of the Commissioner that the taxpayer, in ascertaining the income, profit, or loss of the taxable year for which the LIFO inventory method is first used, or for any subsequent taxable year, for credit purposes or for purposes of reports to shareholders, partners, other proprietors, or beneficiaries, has not used any inventory method other than LIFO.

Treas. Reg. section 1.472-2(e)(1) generally provides exceptions to the LIFO conformity requirement. Under Treas. Reg. section 1.472-2(e)(1)(iv), a taxpayer is not at variance with the LIFO conformity requirement if it uses an inventory method other than LIFO in a report or statement covering a period of less than an entire taxable year. However, Treas. Reg. section 1.472-2(e)(6) provides that a series of credit statements or financial reports is considered a single statement or report covering an entire taxable year if the statements or reports in the series are prepared using a single inventory method and can be combined to disclose the income, profit, or loss for the entire taxable year. For this purpose a taxable year includes any 1-year period that both begins and ends in a taxable year for which the taxpayer used the LIFO inventory method. See Treas. Reg. section 1.472-2(e)(2).  Thus, income statements prepared on the basis of a calendar year may be subject to the LIFO conformity requirement even though the taxpayer employs a fiscal year for federal income tax purposes.

Under Treas. Reg. section 1.472-2(e)(2)(vi), a taxpayer is not at variance with the LIFO conformity requirement if it uses costing methods or accounting methods to ascertain income, profit, or loss in financial statements for credit purposes if such methods are not inconsistent with the LIFO inventory method. The use of cost estimates is an example of a costing method that is not inconsistent with the LIFO inventory method. See Treas. Reg. section 1.472-2(e)(8)(ix).

A taxpayer subject to these conformity requirements may have the LIFO election terminated for a conformity violation. In determining whether there exists a LIFO conformity violation, it is important to examine the automobile dealer's financial statement disclosures to the manufacturer and to the entities (creditors) that "floor plan" the dealer's inventory, regardless of whether a particular creditor is an affiliate of the manufacturer or outside party. Refer to Rev. Proc. 79-23.

In Rev. Proc. 97-44, I.R.B. 1997-41, (September 25, 1997), the IRS provided relief for franchised automobile dealers that have violated the LIFO conformity requirement. This revenue procedure provides relief for automobile dealers that elected the last-in, first-out (LIFO) inventory method and violated the LIFO conformity requirement of section 472(c) or (e)(2) of the Internal Revenue Code by providing, for credit purposes, an income statement prepared in a format required by the franchisor or on a pre-printed form supplied by the franchisor (an automobile manufacturer), covering any taxable year ended on or before October 14, 1997, that fails to reflect the LIFO inventory method. See, e.g., Rev. Rul. 97-42, 1997-41 I.R.B. (Situation 3). Automobile dealers that comply with this revenue procedure will not be required to change from the LIFO inventory method to another inventory method as a result of such LIFO conformity violation. Taxpayers that elected this relief were required to make three catch up payments to avoid being terminated.

Revenue agents should at a minimum, inquire if the taxpayer elected the above relief. If the taxpayer did elect the above relief, verify the required three payments were made.  If the taxpayer did not elect the relief, the agent must check to see if the taxpayer is in violation of the LIFO conformity requirements under IRC section 472. Even if they did elect the relief, taxpayers are required to continue to comply with the requirements of the regulations.  Rev. Proc. 98-46 extended the relief in Rev. Proc. 97-44 to medium and heavy truck dealers.

  1. What are the record keeping requirements?
    A taxpayer electing LIFO agrees to maintain adequate records to comply with the regulations. Treas. Reg. section 1.472-2(h) requires a taxpayer electing LIFO to maintain records supporting the LIFO computations and compliance with the LIFO regulations. Treas. Reg. section 1.472-2(h) places a substantial responsibility on the taxpayer since, under the LIFO reverse order principle, the costs in ending inventories relate to years all the way back to the year of the initial LIFO election. A taxpayer may have the LIFO election terminated for non-compliance. See H.E. Boecking, Jr. and Sally Boecking v. Commissioner, T.C. Memo. 1993-497, CCH 49,362(M). See Treas. Reg. section 1.472-8(e)(1).

  2. How do write-downs affect the LIFO election?
    LIFO is a cost method. Write-downs from cost are not permitted. A taxpayer as part of the election must restore to the base year inventories all cost write downs to items on hand. This means restoration must be made to the beginning inventory in the first year covered by the LIFO election.

The write downs that must be restored (and that cannot be subsequently claimed as long as the LIFO election is in effect) include "lower of cost or market" write downs, Treas. Reg. section 1.471-4, as well as "subnormal goods" write-downs. See Treas. Reg. section 1.471-2, Rev. Rul. 76-282, and Rev. Proc. 76-28, 1976-2 C.B. 645.

Under elections made prior to December 31, 1981, the restoration had to be made on an amended return for the tax year immediately preceding the year of the LIFO election. See Rev. Proc. 76-6. For elections made after December 31, 1981, IRC section 472(d) requires the restoration to be made pro rata over 3 tax years beginning with the year of the LIFO election. The 3-year analysis that is required to be attached to the Form 970 provides the information for the restoration.

The use of the lower of LIFO or cost or market for financial statements is not a violation of the conformity requirement although the write-down must be restored for tax purposes. See TAM 8402015.

  1. How can the LIFO election be terminated?
    The service can terminate the use of the LIFO method by a taxpayer who has adopted LIFO without filing Form 970. There may be an exception to this rule if the taxpayer includes all of the information on the tax return that is required on the Form 970. Fischer Industries Inc. and Subsidiaries v. Commissioner, 87 T.C. 116 (1986).

The method may also be terminated if the financial reporting requirements are not complied with (see above), or adequate records are not maintained (see above).

The 1987 Revenue Act added IRC section 1363(d), which requires that a C-Corporation using the LIFO method who converts to an S-Corporation must recapture its LIFO reserve and pay the tax over a 4 year period. This provision was effective after December 17, 1987.

For more information, refer to Rev. Proc. 79-23, 1979-1 C.B. 564, 1979. 

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Computations
Index

The examination of an auto dealership's LIFO begins with a determination of the appropriateness of the taxpayer's indices. A complete examination of the taxpayer's computations would require a great deal of both the Government's and taxpayer's time and resources. The agent should determine if issues are likely to exist, before embarking upon a complete examination of these indices.

The first thing the agent needs to do is to secure the Form 970 and determine which Dollar Value method the taxpayer has elected to price its inventory. In the auto dealership context, there are three such pricing methods; the Double Extension Method, the Link Chain Method and the Index method. The Link Chain Method is the most prevalent in this industry and will be the focus of this discussion.

The LIFO years should be determined by reviewing the Form 970. From this form, the agent can ascertain the method the taxpayer has elected to determine current year costs of the units in ending inventory in order to compute the index.  Recall many auto dealerships elect the Earliest Acquisitions Method, also known as the First Purchases Method or the Most Recent Purchases, also known as the Latest Acquisitions Method. Taxpayers may elect the most recent Purchases method but, in fact, may be using the specific identification method. This is not an unauthorized change in method of accounting if it has been consistently used from the date of election.

To compute the LIFO index, both the latest acquisition and earliest acquisition methods require comparison of each vehicle in the current year's ending inventory to a similarly equipped vehicle in the prior year. The difference between the two methods lies in which purchase cost is used in the computation.

Dealers that elect to use the latest acquisition method must determine the last purchase (latest acquisition), during the current year, of each vehicle in ending inventory. (For latest acquisition, generally the vehicle on hand at the end of the year is the latest acquisition.) The cost of the latest acquisition of the vehicle must be compared to the cost of the latest purchase in the prior year of a similarly equipped vehicle.

Dealers that elect to use the earliest acquisition method must determine the first purchase (earliest acquisition), during the current year, of each vehicle in ending inventory. The earliest acquisition must be determined for a vehicle similarly equipped to the vehicle in ending inventory. The cost of the first purchase of the vehicle must then be compared to the cost of the first purchase of a similarly equipped vehicle in the prior year.

For example: the dealer has in ending inventory a fully loaded Dodge Intrepid.  Review of purchase invoices indicates that the dealer first purchased a similarly equipped Intrepid in May of the current year. The cost of the May purchase is the current year cost for purposes of computing the LIFO index. The dealer must then analyze vehicle purchases for the prior tax year and determine the first purchase of a similarly equipped Dodge Intrepid. The cost of the first purchase in the prior year is the prior year cost for the purpose of the LIFO computation. 

Regardless of which method is elected, if the vehicle is determined to be a new item for purposes of the LIFO computation, the prior year cost is the same as the current year cost, i.e. 1.00 index. (Current year cost is determined as noted above.)

From these invoices, the indices will be created. The agent needs to determine the manufacturer, model year and model type of the various distinct vehicles the dealership has in ending inventory, separated into two pools, cars and trucks. This is necessary to insure the same vehicles are being "compared" during the applicable measuring periods. To illustrate this concept consider the following: 

The current year and year of examination is 9312. The first year of the dealership LIFO election was for the year ending December 31, 1991. The Form 970 indicates this taxpayer has elected to use the Link Chain, Latest Acquisitions Method to value the inventory.  Review of the general ledger indicates the 9112 dealership ending inventory has a dollar value of $224,000. This dollar value was represented by the following vehicles:

Model Year 1992 - December 31, 1991

Model  Quantity Cost Extended Cost
Car A 1 $22,000  $ 22,000
Car B  2 23,000 46,000
Car C 6 26,000 156,000
Base Year Cost 9112

    

     

$224,000

You have obtained the necessary general ledger entries and invoices and have determined the following apply to 9212 and 9312 regarding this election:

Model Year 1993 - December 31, 1992

Extended Model  Quantity Cost Cost
Car A 5 $22,880  $114,400
Car B 6 23,920 143,520
Car C 9 27,040 243,360
Current Year Cost 9212             $501,280

  

Model Year 1994 - December 31, 1993

Extended Model  Quantity Cost Cost
Car A 6 $24,024  $144,144
Car B 25,116 175,812
Car C 10 28,392 283,920
Current Year Cost 9312           $603,876

From this information the indices for each of the 3 years of this election can be computed as follows:

The 1991 LIFO Index is 1.000. This is the Base Year of the election. There are no prior items in the inventory.
The 1992 LIFO Index is 1.040. This was determined as follows:

Car Pool 9212
Model Year 1993
           

Prior Year

Current Year

Model End Inv Quantity As of 1991
Vehicle Price
As of 1991
Extended Price
As of 1992
Vehicle Price
As of 1992
Extended Price
Car A 5 $22,000 $110,000 $22,880 $114,400
Car B 6 23,000 138,000 23,920 143,520
Car C 9 26,000 234,000 27,040 243,360
      20

      

$482,000

      

$501,280

Car Pool Index: $501,280 / $482,000 = 1.040

The 1993 LIFO Index is 1.050. This was determined as follows:

Car Pool 9312
Model Year 1994
           

Prior Year

Current Year

Model End Inv Quantity As of 1992
Vehicle Price
As of 1992
Extended Price
As of 1993
Vehicle Price
As of 1993
Extended Price
Car A 6 $22,880 $137,280 $24,024 $144,144
Car B 7 23,920  167,440 25,116 175,812
Car C 10 27,040 270,400 28,392 283,920
    23

      

$575,120

      

$603,876

Car Pool Index: $603,876 / $575,120 = 1.050

It is possible for the price of a vehicle to go down from one year to the next. Such deflation will be accounted for in the index using the same steps which were used to compute inflation.

Where no invoice exists or price cannot be reconstructed for a particular vehicle, for a specific year, the assumption may be made this is a new vehicle entering the inventory and no inflation can be assigned. Any such particular vehicle will receive an index of 1.0000. The dealer may submit information to the contrary which should be considered by the agent. See the section on "Pooling" above, for guidance on determining whether a new item is present.

Once the indices have been calculated the next step of the LIFO computation will be to determine the LIFO layers to add to the reserve.

Please see the Appendix section of this Guide for a comprehensive case study detailing the computation of indices used to compute a LIFO Reserve.

BLS Sanity Check
A simpler means to "ballpark" the taxpayer's LIFO reserve without a great deal of time is referred to as the Bureau of Labor Statistics (BLS) "sanity check."  Depending on how detailed the agent wants to get, you can request the taxpayer's yearly non-LIFO and LIFO values and recompute the entire reserve in several minutes, or you can simply compare the taxpayer's indexes to the relevant BLS indexes. This can provide a quick analysis, but should not solely be used to make an adjustment if that is not the method that has been elected.  Factors to keep in mind when using these tables include:

  1. Producer Price Index (PPI) - domestic manufacturers

  2. Consumer Price Index (CPI) - foreign manufacturers

  3. Use quarter closest to taxpayer's taxable yearend

  4. Trucks GVW 10,000 lbs. and under (PPI only)

  5. Trucks over 10,000 lbs. GVW (PPI only).

Reserve
An increment in the LIFO inventory occurs when the end of the year inventory for any pool expressed in terms of base-year cost is in excess of the beginning of the year inventory for that pool expressed in terms of base-year cost. See Treas. Reg. section 1.472-8(a).

If there is an increment for the taxable year, the ratio of the total current year cost of the pool to the total base year cost of the pool must be computed. This ratio, when multiplied by the amount of the increment measured in terms of base year costs, gives the LIFO inventory value of such increment. The LIFO inventory value of each such increment is referred to in this section as the "layer" and must be separately accounted for and a record thereof maintained as a separate layer of the pool, and may not be combined with a layer of increment occurring in a different year.

On the other hand, when the end of year inventory expressed in terms of the base-year cost of the pool is less than the beginning base-year cost of the pool, a decrement occurs in the pool for that year. Such a decrement, or liquidation, is to be reflected by reducing the most recent layer of increment by the excess of the beginning of the year inventory (expressed in terms of base year cost) over the end of the year inventory (expressed in terms of base year cost) of the pool. However, if the amount of liquidation exceeds the amount of the most recent layer of increment, the preceding layers of increment in reverse chronological order are to be successively reduced by the amount of such excess until all the excess is absorbed. The base year inventory is to be reduced by liquidation only after the aggregate of all liquidations exceeds the aggregate of all layers of increment. The liquidation process works the same whether it is under the double extension, link chain or any other method.

The LIFO Reserve calculation, just as with the increment valuation, is the same no matter what method of LIFO the taxpayer elects. The equation for the LIFO reserve is as follows:

NON-LIFO     (Inventory per General Ledger) (usually specific cost)
       (LIFO)                  (Less: LIFO Inventory Value)
RESERVE             (Cumulative Reserve)

The LIFO reserve shown in the equation is the "Cumulative LIFO Reserve Balance," which is what you should see on the Balance Sheet of the return under "Inventory." This is the amount of reserve that has accumulated over the years since LIFO was first elected. A cumulative amount of reserve is maintained because it represents the present the value of the inventories. If the dealer ever terminates LIFO, the reserve will have to be recaptured.

To find out how much the dealer has deducted each year as a current year adjustment on the reserve, it is necessary to subtract the prior year's cumulative LIFO reserve. The difference is the amount to be adjusted in the current year.

To illustrate these principles, consider the index example introduced in the previous section as an aid to demonstrate the mechanics of computing the LIFO 
Reserve:

The Base Year was 1991. The Base Year Cost was $224,000. There was no prior inventory.

The taxpayer elected Dollar Value Link Chain LIFO.

The dealership had the following cars in ending inventory on December 31, 1991:

Model Year 1992 - December 31, 1991

Model  Quantity Cost Extended Cost
Car A 1 $22,000  $ 22,000
Car B  2 23,000 46,000
Car C 6 26,000 156,000
Base Year Cost 9112

     

     

$224,000

At December 31, 1992, Model Year 1993, the dealership had the following vehicles in ending inventory:

Quantity Model CYC Extended CYC BOYC Extended BOYC

5

Car A $22,880 $114,400 $22,000 $110,000

6

Car B 23,920 143,520 23,000 138,000

9

Car C 27,040 243,360 26,000 234,000

20

     

     

$501,280

     

$482,000

BOYC = Beginning of Year Costs. This is the December 31, 1991, price of the same vehicle showing in the December 31, 1992, ending inventory.

CYC = Current Year Cost. This is the price at December 31, 1992, of the 1993 Models in the December 31, 1992, ending inventory.

                    The 1992 LIFO Index is 1.04:

        LIFO INDEX = (TOTAL CYC / TOTAL BOYC)

                $501,280 / $482,000 = 1.04

        The 1992 Cumulative Index is 1.04:

(1992 LIFO INDEX x BASE YEAR INDEX)

1.04 x 1.000 = 1.04

The value of the 9212 Ending Inventory at Base Year Cost is $482,000.

            $501,280 / 1.04 = $482,000

(1992 CURRENT YEAR COST / 1992 CUMULATIVE INDEX)

Computation of 1992 Increment and Reserve Addition

      Base Year Cost Cumm. Index LIFO Value

Base Year Inventory

$224,000  1.000 $224,000

1992 Increment 

258,000 1.040 268,320
      $482,000

   

$492,320

The 1992 Increment at Base Year Cost ($258,000) is derived by subtracting the Base Year Inventory from the 9212 Ending Inventory at Base Year Cost.

9212 Ending Inventory at Base Year Cost $482,000
- Base Year Inventory                                  (224,000)
1992 Increment                                            $258,000

The 1992 LIFO Value is derived by multiplying the 1992 Increment by the 1992 Cumulative Index, then adding this product to the product of the Prior Year LIFO value which in this example is determined by multiplying the Base Year Cost by the Base Year Index.

Base Year Inventory              $224,000 x 1.000 = $224,000
1992 Increment                     $258,000 x 1.040 = +268,320
1992 LIFO Value                                                     $492,320

The 1992 LIFO Reserve
    Total Current Year Cost         $501,280
    Less: 1992 LIFO Value         (492,320)
    1992 Reserve Addition             $8,960

At December 31, 1993, Model Year 1994, the dealership had the following vehicles in ending inventory:

Quantity Model CYC Extended CYC BOYC Extended BOYC

6

Car A $24,024 $144,144 $22,880 $137,280

7

Car B 25,116 175,812 23,920 167,440

10

Car C 28,392 283,920 27,040 270,400

23

    

     

$603,876

     

$575,120

BOYC = Beginning of Year Costs. This is the December 31, 1992, price of the same vehicle showing in the December 31, 1993, ending inventory.
CYC = Current Year Cost. This is the price at December 31, 1993, of the 1994 Models in the December 31, 1993, ending inventory.

The 1993 LIFO Index is 1.050:

(TOTAL CYC / TOTAL BOYC)

$603,876 / $575,120 = 1.050

    The 1993 Cumulative Index is 1.092:

(1993 LIFO INDEX x 1992 CUMULATIVE LIFO INDEX)

1.050 x 1.040 = 1.092

The value of the 9312 Ending Inventory at Base Year Cost is $553,000.

(1993 CURRENT YEAR COST / 1993 CUMULATIVE INDEX)    
                              $603,876 / 1.092 = $553,000

Computation of 1993 Increment and Reserve Addition

      Base Year Cost Cumm. Index LIFO Value
Base Year Inventory $224,000 1.000 $224,000
1992 Increment  258,000 1.040 268,320
1993 Increment 71,000 1.092 77,532
      $553,000

     

 $569,852

The 1993 Increment at Base Year Cost ($71,000) is derived by subtracting the Base Year Inventory and the 1992 Increment from the 9312 Ending Inventory at Base Year Cost.

9312 Ending Inventory at Base Year Cost         $553,000
1992 Increment                                                     (258,000)
- Base Year Inventory                                           (224,000)
1993 Increment                                                       $71,000

The 1993 LIFO Value is derived by multiplying the 1993 Increment by the 1993 Cumulative Index, then adding this product to the product of the Prior Year LIFO value which in this example is determined by multiplying the Base Year Cost by the Base Year Index and the product of the 1992 increment multiplied by the 1992 Cumulative Index.

Base Year Inventory                     $224,000 x 1.000 =  $224,000
1992 Increment                               258,000 x 1.040 = + 268,320
1993 Increment                                 71,000 x 1.092 = +   77,532
1993 LIFO Value                                                             $569,852

The 1993 Cumulative LIFO Reserve
    Total Current Year Cost         $ 603,876
    Less: 1993 LIFO Value          (569,852)
    LIFO Reserve                           $ 34,024

Current Year Addition to LIFO Reserve:
    1993 Reserve                         $34,024
    Less 1992 Reserve                (8,960)
    Addition to Reserve              $25,064

The amount of the addition to the reserve in the current year is the excess of the required reserve over the prior year's reserve.

Simplified LIFO Method: IRC section 474
All taxpayers, except retailers, may elect this Inventory Price Index (IPI) method applying to taxable years beginning after 1981. Manufacturers, processors, wholesalers, jobbers and distributors must use the Producer Prices and Producer Price Index tables. Retailers may use either the Producer Price Index or Consumer Price Index tables.

Small business taxpayers as defined by IRC section 474, contemplate a taxpayer whose average annual gross receipts for 3 preceding taxable years does not exceed $5,000,000. They may use 100 percent of the stated index change, whereas taxpayers who exceed the $5,000,000 gross receipts test may use 80 percent of the change in the BLS indices.

Generally, this IPI method will not be encountered because of the gross receipts test. Auto dealer’s gross receipts are usually in excess of $5,000,000.

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Page Last Reviewed or Updated: 27-Nov-2013