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New Vehicle Dealership Audit Technique Guide 2004 - Chapter 4 - Inventory (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 3 | Table of Contents | Chapter 5

Chapter 4 - Table of Content

LIFO Background
Short History of LIFO Applications

Automobile dealerships have a great deal of discretion in what accounting methods they will employ for various classes of their inventoried items. Whatever method the taxpayer chooses, it must clearly reflect income. If there is confidence in the taxpayer's books and records, the scope of the inquiry into inventory can be narrowed, allowing the agent to dedicate audit resources to specific examination techniques:

  1. Make sure everything that should be inventoried is included in an inventory account.

  2. Verify that an allowable method is being used.

  3. Scrutinize any adjustments made to inventory accounts.

Auto dealerships typically maintain distinct inventories and tend to account for them differently. Among the types of inventoried items are:

  1. New vehicles

  2. Used vehicles

  3. Parts and Accessories

The methods used for valuing and accounting for these classes of items do differ from dealership to dealership but are generally directed by the size of the firm. We can look at inventory issues as falling into one of three categories:

Used Car Dealerships:
The smaller "lots" usually do not wish to invest the time, energy, and financial resources into a complex inventory system. They tend to use Lower of Cost or Market (LCM) to value vehicles and do not maintain any other inventories. At yearend, a valuation guide may be used to value the automobiles on an individual basis using 100 percent of the average wholesale valuation quote. The dealership then determines an ending inventory adjustment for the year. (See Rev. Rul. 67-107 and Treas. Reg. section 1.471.4)

Smaller New Vehicle Dealerships:
This middle class of dealerships may employ any range of inventory techniques with little consistency among them. The dealerships range from small low volume motorcycle shops to medium sized multi-vehicle type lots. Here it is important to make sure that all items that should be inventoried are being correctly accounted for. It is not uncommon for a dealer of this size to inventory vehicles and expense parts and accessories. In any case, the method of valuation should be determined and inventory physically observed. The agent should determine the actual physical inventory, compare it to the amount shown on the tax return and make an adjustment for the difference.

Large Multi-Entity Dealerships:
For tax purposes, the large dealerships may use LIFO for new vehicles, used vehicles, and parts and accessories with profit center costing allocations. They often have related used car and truck ventures, usually resulting from trade-ins for new vehicles sold. These trade-ins may be accounted for under the LCM method discussed previously. Certain items are accounted for under the specific identification method due to rarity, such as repossessions. The lower of cost of market can be used for these items under the rules discussed for used vehicles. It is recommended that all inventories be scrutinized as they have a material impact on taxable income and could be valued incorrectly.

The various methods of inventory valuation and the authority for utilizing them are:

 First-in, First-out (FIFO), Treas. Reg. section 1.471-2(d)(2)

  1. Lower of Cost or Market (LCM), Treas. Reg. section 1.471-2(c)

  2. Specific Identification, Treas. Reg. section 1.471-3

  3. Last-in, First-out (LIFO), Treas. Reg. section 1.472

FIFO is only advantageous in a deflationary economy, and historically the United States economy has exhibited inflationary tendencies, therefore it is improbable an auto dealership would use the FIFO method of inventory valuation. LCM on the other hand, offers an attractive method for handling used vehicles since their value at the end of the year may be less. Most, if not all, dealerships use specific identification for the inventory value of new vehicles for book purposes. This is based on the actual flow of goods. FIFO is an assumed flow of goods and is different from specific identification (cost or LCM) or LIFO. They may not use FIFO for vehicle inventory since the vehicles can be identified with specific invoices.

Lastly, LIFO, given the inflationary nature of the United States economy, is attractive to auto dealers and is frequently the inventory valuation method of choice. Full consideration of this topic demands a working knowledge of the rules and procedures governing it.

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LIFO Background

Overview of the Method:
A large problem area concerning the examination of auto dealerships occurs where the LIFO method of inventory valuation is used. This has been a problem due to the technical complexity of the method coupled with the volumes of records that must be examined to determine whether there is compliance. Auto dealerships elect the LIFO method because the benefits offered outweigh the negative aspects of its use for most. During inflationary times taxes are deferred by changing the flow of costing inventory through a sequence of valuation steps.

The last costs incurred are placed into the cost of sales and the earliest costs are retained as inventory (layers). This means that units in ending inventory are valued at the oldest unit costs available and units in cost of goods sold are valued at the newest unit costs available. Accordingly, the LIFO method of valuation reverses the normal (assumed) flow of costs reflected in the FIFO (cost) method. LIFO is merely removing inflation from ending inventory and expensing it as part of the cost of goods sold.

When comparing the flow of LIFO costs to the flow of FIFO costs, we see that FIFO charges the cost of inventory items to cost of sales in the order of their acquisition. The cost of the inventory on the balance sheet under the FIFO method more clearly reflects the replacement cost than does the LIFO method. Under the FIFO method, when inventory is sold and then replaced at a higher cost, the difference between the inventories' selling price and the replacement cost, causes recognition of a phantom profit and fails in an economic sense to provide the best matching of costs and revenues.

The LIFO approach attempts to match the most recent costs of purchases from the computation of inventory costs. Where LIFO is used, if prices increase, a deferral of taxes will result and profits are decreased. The later higher costs are charged to costs of sales and earlier lower costs remain in inventory. This means inventory costs are removed in the reverse order of their acquisition.

The difference between the LIFO and non-LIFO inventory values is called the LIFO Reserve. The LIFO reserve represents the inflation that has been deducted through increasing Cost of Goods Sold, which results in lower taxes. It is important to note that the reserve must be brought back into income at some future date. The reserve is only a temporary deferral, not a permanent one; a timing difference. To better understand LIFO concepts, see, Amity Leather Products Co. v. Commissioner, 82 T.C. 726 (1984), Hamilton Industries, Inc., Successor of Mayline Company, Inc. and Subsidiary v. Commissioner, 97 T.C. 120 (1991), and Fox Chevrolet, Inc. (Maryland) v. Commissioner, 76 T.C. 708 (1981).
LIFO has taken on complexity that may or may not have been intended. To appreciate the problems associated with the election by automobile dealers to value their inventories using this method, we may want to see where this complexity began and have an understanding of problems present today.

Origins of the Method:
Prior to 1939, taxpayers were only allowed to use the specific identification and the FIFO methods of inventory valuation. Taxpayer litigation seeking permission to use a LIFO forerunner was fruitless to this point. See Lucas v. Kansas City Structural Steel Company, 281 U.S. 264 (1930).

The Revenue Act of 1939 extended the privilege to use the LIFO method to all taxpayers. Along with the privilege of using LIFO for tax purposes, the 1939 Act also instituted a strict financial reporting conformity requirement.

Regulations issued pursuant to the 1939 Act indicated that the use of LIFO would only be allowed to taxpayers with few basic fungible commodities that could be measured in terms of common units, such as tons, yards, barrels, etc. As a result of the limitations imposed, the "specific goods" or unit LIFO method was the only official method authorized.

Under the specific goods method, taxpayers with diverse and non-homogeneous inventories, such as motor vehicles, could not, as a practical matter, use the specific unit method. Taxpayers with such non-fungible inventories were, in effect, denied the use of the LIFO method of accounting.

The Revenue Act of 1942 made two major changes to the LIFO method of accounting. First, the reporting requirement mandated in the 1939 Act was burdensome. It applied to all financial reports. Congress relaxed the requirement by limiting its application to annual reports.

Second, prior to this Act, as stated above, the specific unit method was the only allowable LIFO method. At this time a concept was introduced using a method which measured changes in inventory investment pools by reference to standard base year dollars and inflation indices relating back to the base year dollars. This dollar value method introduced a significant concept, which is referred to as "pooling," which considers a grouping of items within a product line. The 1942 Act authorized limited application of the dollar value method. In 1949, the LIFO regulations were amended permitting all taxpayers to use the dollar value method. See T.D. 5756, 1949-2 C.B. 21.

In 1961, final dollar value regulations were issued. These remained virtually unchanged until 1981. In the Economic Recovery Act of 1981, Congress enacted a number of provisions designed to simplify the LIFO method and make it more accessible to small businesses. See IRC section 472(f), allowing use of certain external indices the producer price index (PPI) and the consumer price index (CPI); IRC section 474 providing a simplified dollar value LIFO method, also known as the IPI Method, applicable to certain small businesses.

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A Short History of LIFO Applications:
Auto Dealership LIFO and the IRS LIFO gained widespread acceptance by automobile dealers in the early 1970s as a result of sharp increases in automobile prices. However, the complexities of the application of dollar value LIFO concepts to the inventories of auto dealerships proved to be difficult to work with not only for automobile dealers but also for practitioners and revenue agents for both technical and practical reasons.

Problems computing dollar value LIFO for the auto dealership industry revolved around two concepts, averaging within submodels and assigning inflation to new vehicles.

A method used by many dealerships defined an item of inventory as the "make," model or sub-model. As quality increased, less expensive vehicles were replaced with more expensive vehicle. By averaging within submodels, higher priced vehicles would be grouped with lower priced vehicle. Though these groupings entailed working within the same model group, this comparison of dissimilar submodels produces an index higher than that attainable by comparing the higher priced submodel vehicles to other like kind higher priced submodel vehicles and lower priced submodel vehicles to other like kind lower priced submodel vehicles.

The following example is offered to illustrate the preceding paragraph:

  1. Averaging Within Submodels




1702 5,967 6,319 50,941 / 48,959= 1.041
1703 6,285 6,654      
1712 6,190 6,543    
1787 7,352 7,669    
1795 7,060 7,360    
1788 7,950 8,121    
1798 8,155 8,275    




  1. Correct Submodel Cost Extension


Unit End Inv 

1985 Cost

1985 Extended 

1986 Cost

1986 Extended

1702 1 5,967 5,967 6,319 6,319 860,222 / 835,077
1703 2 6,285 12,570 6,654 13,308  = 1.030
1712 1 6,190 6,190 6,543 6,543    
1787 25 7,352 183,800 7,669 191,725    
1795 26 7,060 183,560 7,360 191,360    
1788 27 7,950 214,650 8,121 219,267    
1798 28 8,155 228,340 8,275 231,700    


835,077   860,222    

Example 1. "Averaging Within Submodels" does not consider actual numbers of units in ending inventory, but only considers the average of specific submodel ranges. The "Correct Submodel Extension" example considers items in ending inventory.

Consider an ending inventory of $2 million. A dealership with only 200 vehicles in ending inventory with a value of $10,000 each would have a $2,000,000 inventory. The difference between application of an index of 1.04 and 1.03 to this inventory is $20,000. ($2,000,000 x 1.04 is 2,080,000; $2,000,000 x 1.03 is $2,060,000.) As an addition to the reserve, this would produce a deferral of the tax on $20,000. As a decrease to gross profit, this would produce a $20,000 cost of goods sold deduction. This example was rather basic and involved only one sub model group. In practice, the results produced by averaging within many submodel groups becomes increasingly material with higher indices using this method.

Another area of concern was that some dealers were comparing newly introduced models to existing items. A new vehicle has no item that preceded it to which a comparison in measuring years could be made to determine inflation.  Therefore, a new vehicle should receive no inflation or an index of 1.000. Another issue was that some dealers did not construct the cost of a new vehicle as required by the regulations.

In some instances new items entering inventory were receiving improper inflation through "reconstructions" of supposed like kind vehicles. In some cases, there was no vehicle that previously existed which could be compared to a new vehicle. Such comparisons known as "reconstructions” could produce higher indices, thus a higher deferral in the reserve and an increased annual cost of goods sold deduction.

There were other problems, including a lack of adequate record retention. Some dealers were not maintaining records, as mandated by the regulations, which would enable the Service to determine the level of dealership compliance. 

An additional problem concerning the computation of option indices was encountered. The Link Chain Method envisions accounting for each item in ending inventory. Once the items in ending inventory are determined, each item needs to be priced and inflation assigned to it. LIFO contemplates two methods of costing or pricing items in ending inventory. One of these pricing methods would be elected on the dealers Form 970. Pricing entails going back 1 year under the Latest Acquisitions Method or 2 years under the Earliest Acquisitions Method.

Application of these methods of costing encompasses the following analysis. If there were 300 vehicles in ending inventory for a particular year, those invoices needed to be secured. It is not uncommon for a midsize dealership to have this volume in ending inventory. The invoices were scheduled and a determination was made that they represent the items in ending inventory. Once this was done, each vehicle was listed showing the current year price and the price for this same item in the preceding year or years, if it was in existence. Doing this with 300 vehicles was cumbersome, but workable. Such was not the case concerning options.

Some domestic vehicles listed almost everything as an option. It was not uncommon for the invoices associated with these domestic vehicles to have 10, or more, options per vehicle. Each option needed specific pricing for the necessary measuring years, just as the vehicles did. Foreign vehicles were better, but not much. Invoices utilized for a particular manufacturer at this time showed about 5 options per vehicle.

The domestic vehicles and associated options for the ending inventory cited above would require individualized accounting and pricing for approximately 3,300 items for each year of the LIFO election using the Latest Acquisitions Method. The number of accounting and pricing requirements would double if the Earliest Acquisitions Method was used. The foreign vehicles cited above would require pricing for approximately 1,800 items under the Latest Acquisitions Method and 3,600 under the Earliest Acquisitions Method for each year of the LIFO election. Some of the cases being worked at this time had 10 years or more of LIFO indices that required individualized accounting and pricing of each item in those ending inventories.

Statistical sampling was contemplated, but deemed not appropriate for two reasons. First, the pure Link Chain Method contemplated actual pricing of each item in ending inventory. Second, the dealers would not allow the Service to perform a statistical sample, although many used one themselves. They wanted the Service to price every item if their indices were going to be challenged knowing this was very difficult, if not impractical.

A solution to this unseemly situation was developed. Working these cases, it was found that options involved "about 10 percent of the dollar value and 90 percent of the work." It was found that by determining the index on vehicles in ending inventory and applying this index to the dollar value of the options, in ending inventory, the differences between the actual option calculation and this simplified method was de minimis. If allowed to proceed with this method, 90 percent of the work could be eliminated and an accurate LIFO index could be computed. This simplified method proved to be quite effective where adequate records were maintained and workable where there were few or no records.

To address these complexities and to provide a workable system to compute automobile LIFO, Rev. Proc. 92-79, superceded by Rev. Proc. 97-36, was issued. This provided a methodology for computing Alternative LIFO for new cars and new light duty trucks. In 2001 Rev. Proc. 2001-23 was issued providing the industry with the Used Vehicle Alternative LIFO Method. 

Rev. Proc. 97-36 allows the auto dealer to compute indices by using a simplified method. The computations were to be arrived at using base to base pricing, comparing vehicles to vehicles, and applying the resulting index to the dollar value of the full inventory. There is no requirement to provide a separate accounting and pricing for options. More on Rev. Proc. 97-36 later in this section. 

The agent who is considering addressing auto dealership LIFO computations for dealers who have not elected Rev. Proc. 97-36, must be cognizant of the "Definition of an Item" coordinated issue which requires inflation analysis for specific components of manufacturers option packages. A copy of this coordinated issue is included in the Appendix of this ATG. 

Some dealerships may have filed a Form 3115 under Rev. Proc. 97-27 to change their computation method. Others may prefer to wait until they are examined and file a Form 3115 in the first 90 days of the examination.

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Chapter 3 | Table of Contents | Chapter 5