High Inflation & Rising Inventory Costs - How Businesses Are Reducing Tax Liabilities

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Gasoline prices have hit $4 a gallon, food prices are escalating, and inflation is in the news. However, there is at least one tool that businesses and accounting professionals can use to help turn a negative into a positive.

In an online article on Inc.com, Joseph E. Stiglitz, winner of the 2001 Nobel Prize in Economics, wrote, "Inflation also presents special problems in terms of accounting, and those who understand those problems can reduce their tax liabilities significantly. Today, most businesses use last-in-first-out, or LIFO, accounting, which subtracts the cost of the latest widget you put in inventory from the cost of the last widget you sold in order to calculate gross profit. Some companies, however, still use first-in-first-out, or FIFO, accounting, which subtracts the cost of the oldest widget in your inventory from the cost of the last widget you sold. In a period of rapid inflation, when the price of widgets is probably on the rise, FIFO companies will appear to be selling their widgets at much higher profit margins than LIFO companies, and their tax liability will be higher as a result. So if you haven't yet made the switch to LIFO accounting, now is the time to do so."

Other than the aforementioned, why should businesses consider LIFO? Regulations issued in 2002 provide favorable opportunities to both LIFO and non-LIFO taxpayers. Becoming familiar with the basic concepts of LIFO and the updated rules will help to:

1) Potentially maximize the tax benefits available to clients or businesses that are already on LIFO;

2) Provide audit protection to clients or businesses that currently use an internally generated LIFO inflation index; and

3) Make a substantial tax benefit available to clients or businesses that have not yet taken advantage of LIFO.

What is LIFO?

LIFO at its core is a cost flow methodology. Under the LIFO method, costs move through inventory in a manner that allocates the most recent costs incurred to cost of sales, while retaining the earliest costs in inventory. Essentially the most recent purchases for a retailer/distributor, or manufactured goods for a manufacturer, are the items considered sold during the current period.

The LIFO cost flow assumption contrasts sharply with the other common inventory methodology, FIFO. Under the FIFO method, the costs of items sold in the current period are considered to be the earliest costs in inventory prior to the sale. While this methodology most closely resembles the natural movement of goods, it generally doesn't value ending inventory at the lowest possible amount. Why? As prices naturally rise, current, more expensive, costs are held in inventory under the FIFO method as compared to the LIFO method.

A significant benefit associated with LIFO is that it attempts to match current costs with current revenues. Current purchases or manufacturing costs are linked directly to current sales. To this end, LIFO's true advantage over the FIFO method is its effectiveness in reducing the impact of price increases on profitability. With all things being equal, after successive annual price increases the value of ending inventory is likely to be substantially less than current replacement costs.

Acronyms to Know: IPIC LIFO Uses PPI and CPI

Like other dollar value LIFO methods, the Inventory Price Index Computation ("IPIC") LIFO method compares current year costs with base year costs to develop an index. Unlike other dollar value LIFO methods, the IPIC method uses external government published indexes rather than indexes that are a result of a business' internal prices.

The IPIC method utilizes the same indexes tracked and reported by trusted cable financial networks and business publications, the Producer Price Index (PPI) or Consumer Price Index (CPI). Every item produced or sold in this country is tied to these government-published indexes. The IPIC method first links a company's inventory to categories within the PPI and CPI. It then compares the change in these indexes from the beginning of a company's tax year to the end of the tax year to determine current year inflation. Lastly, each item's inflation is weighted by the dollar value of the item to the total dollar value of ending inventory to determine an overall inflation index. This index represents the overall change in inventory prices from the beginning of the year to the end of the year.

What's so special about using external indexes under the IPIC method?

There are three primary answers to this question: simplification, IRS acceptance, and the possibility of additional tax savings.

Simplification - Implementation of the IPIC LIFO method allows businesses the benefit of LIFO without tracking price changes for all of its many inventory items, which often total in the thousands. Internal recordkeeping is significantly diminished when a detailed inventory listing linked to PPI or CPI categories is all that is needed to compute current year inflation. Some companies spend weeks rebuilding prices in order to perform a LIFO calculation that may or may not result in a benefit. Under IPIC, beginning indexes from the prior year are already known; the company only needs to populate year-end indexes.

IRS Acceptance - The IRS understands the IPIC LIFO methodology and actually approves of the method. With the issuance of the new §472 regulations effective for taxable years ending on or after December 31, 2001, Treasury further simplified the IPIC method and reiterated its desire for companies to move to the IPIC method by giving audit protection to businesses' prior methods if they would simply convert to the IPIC method. Retailers, manufacturers and even companies dealing in commodities have been encouraged by the IRS (sometimes upon audit) to switch to the IPIC method.

Additional Benefit - Many taxpayers realize lower inventory values and better tax savings under the IPIC LIFO method. Whether switching cost flow methods from FIFO to LIFO or simply moving from an existing internal LIFO method, the IPIC LIFO method has the potential to increase current and future year deductions by reducing ending inventory compared to other methods.

External indexes are a composite of the entire industry, specifically domestic production and consumption. Participants in the industry are asked to share their cost/price experience. The PPI or CPI directly reflects this information. Companies that are more efficient in manufacturing operations or that can secure lower purchase prices from their suppliers usually see less internal inflation as compared to their overall industry. As a result, the external indexes give them a better result because inflation is a good thing where LIFO is concerned. In addition, the IPIC method is somewhat flexible in its use of sub-methods. Where there is choice and flexibility, there is opportunity.

Why Consider LIFO Now?

One word: Inflation. Inflation has a material impact on business. If the items being stocked at the front of the shelf cost more than the items at the back of the shelf and these are the items that are sold, cost of goods sold will be higher and ending inventory lower. Higher cost of goods sold means higher current period expense and less tax. What better way to mitigate the precarious profit siphoning aspect of inflation?

Keys to Implementing a Successful IPIC LIFO Implementation

There are several ways to take advantage of this opportunity. First, developing an understanding of Treasury Regulations §1.472-8 is necessary to understand how to properly apply the IPIC method. Whether implementing in-house or using a third party provider, the key questions should include:

1. Are inventory items properly classified to the most detailed PPI or CPI categories?

2. What pooling methodology is most appropriate?

3. Which month is "appropriate" for use in determining the annual inflation index by pool?

4. Should a "representative" month be chosen as opposed to an "appropriate" month?

5. Which indexes, preliminary or final, should be chosen to measure inflation?

6. Does the "10% grouping" option yield a lower inventory value for the business?

Answers to these questions and subsequent implementation decisions will make a substantial difference in the amount of benefit realized from an IPIC LIFO implementation. Proper analysis of these variables, through objective modeling, is worth the time and effort spent on the exercise.

Inflation is making its grand entrance into the boardrooms of many businesses in the country, but LIFO can help mitigate the negative impact of inflation. The LIFO accounting method is the businesses and CPA's best defense against inflation. And, whether already on LIFO or not, the IPIC method makes LIFO even more advantageous for today's businesses.

About SourceCorp Professional Services

Celebrating their 25th year in business, SourceCorp Professional Services is the leading provider of LIFO Accounting, R&D Tax Credit Studies, Cost Segregation Studies, and Green Building 179D Certification/Analysis in North America. With a specialized team of nearly 70 professionals and with offices located throughout the country, accounting firms realize unparalleled experience, services, and trust. SourceCorp serves many of the nation's most prominent CPA firms, Associations, and Fortune 1000 companies. For more information, please visit: http://www.SourceCorpTax.com.

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