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LIFO Recordkeeping and Compliance

The main advantage of using the LIFO method of accounting for inventory costs is to eliminate "inventory profits" in periods of rising costs. LIFO allocates the most current inventory costs to cost of sales, allowing taxpayers to more clearly match current costs with current sales. In periods of rising prices (and increasing inventory quantities), the taxpayer can lock in lower prices in inventory. Other benefits of using LIFO may be lower personal property taxes or decreased expenses directly related to income, such as bonuses or profit-sharing payments.

Taxpayers elect to use the LIFO inventory method (and the resulting increased recordkeeping required to maintain this method) to reap these benefits. These same taxpayers should be aware, however, of the necessary recordkeeping requirements, as failure to comply could result in LIFO termination. Regs. Sec. 1.472-2(h) provides that supplemental and detailed inventory records shall be maintained to enable the district director to readily verify a taxpayer's inventory computations, as well as its compliance with the LIFO requirements. In addition, on examination, the propriety of all computations incidental to the use of LIFO are subject to the IRS's discretion in deciding whether the taxpayer may continue to stay on LIFO (Regs. Sec. 1.472-3(d)).

In Field Service Advice (FSA) 9920002, the taxpayer elected LIFO in fiscal year 1, then later filed an election for the use of multiple pools. The taxpayer requested a change in accounting method in fiscal year 2, and was granted permission to use a single pool as well as the double extension method of accounting for its LIFO inventory. The taxpayer, a retail jeweler, included in its single pool primarily finished goods inventory; also included in the pool were diamonds and semi-precious stones, classified by weight. This method continued until fiscal year 4, at which time the taxpayer began a different accounting for its items. The number of items within the pool increased tenfold, and the cost was accounted for using three component parts—the amount of gold in the merchandise, the type of stone in the merchandise and the difference of the first two over the total costs of the merchandise.

The taxpayer manually prepared accounting records when it elected LIFO; it maintained inventory records by item, including the cost and date purchased. The taxpayer then switched to a computerized accounting system that tracked inventory in the same manner. On examination, the taxpayer no longer had available the original invoices or inventory listings from the period it used the manual accounting system, or invoices from when it began using the computerized system. The Service could not verify the indexes used by the taxpayer; there was insufficient information available to repeat the taxpayer's calculations and arrive at the same indexes. The IRS contended that the taxpayer should have retained invoices to verify its inventory. The taxpayer's argument that the accountants had already verified the LIFO computations via their access to the original books and records was not deemed satisfactory.

In essence, FSA 9920002 concluded that the Service may terminate a taxpayer's LIFO election for failure to maintain adequate records. It stated that "adequate records pertaining to LIFO calculations requires that supporting accounting data, invoices and records, should be kept as appropriate...Failure to maintain original inventory records sufficient to enable the Service to verify LIFO calculations could fail the record-keeping requirement and permit termination." Further, it stated that adequacy of records is a case-by-case determination (Rev. Proc. 79-23).

In addition to recommending LIFO termination, the Service also challenged the taxpayer's recharacterization of items included in the LIFO pool, contending that such a change constituted an accounting method change that required IRS consent.

Regs. Sec. 1.446-1(e)(2)(ii)(b) provides that a change in treatment due to a change in underlying facts does not constitute an accounting method change. The taxpayer contended that the introduction of less expensive rings and diamonds into inventory constituted a substantial change in its product mix and, therefore, a change in the underlying facts. However, the agent concluded, and the Service concurred, that the tenfold increase in pooled inventory was an increase only in the quantity of less expensive jewelry compared to more expensive jewelry, both of which the taxpayer carried at the time it changed its method of accounting for LIFO in fiscal year 2. A change in the degree to which certain items are carried in inventory did not constitute a "factual change related to Taxpayer's existing item definition." Instead, the taxpayer affected the timing of income by altering the definition of items within a pool and changing the treatment of inventory, and, thus, made a change in accounting method under Regs. Sec. 1.446-1. Because the change in accounting method was not approved by the IRS, the taxpayer was instructed to continue to use the original number of items in its pool.

The Service has been persistent in its examination of taxpayer conformance with the technical requirements for adoption and use of LIFO. Taxpayers are advised to reevaluate their current recordkeeping procedures and consistency in applying this method of accounting for inventory. Involuntary LIFO termination can result in significant Sec. 481(a) adjustments; however, with diligence, taxpayers should be able to avoid such an outcome.

While the recordkeeping requirements are not well defined, a taxpayer should at least maintain records that will allow the IRS to verify LIFO calculations for the LIFO procedures it has elected; as in FSA 9920002, an accountant's verification of calculations is not sufficient. Additionally, IRS Letter Ruling (TAM) 8851001 favorably held that taxpayers need not maintain records to support a different set of procedures that the Service would deem more appropriate on examination. Consistency in application of LIFO methodology is extremely important as well; inconsistent application only adds fuel to the fire.

An argument has been made that detailed records should be retained for all open tax years (e.g., inventory listings, supporting cost accounting records and invoices). After a tax year has been barred by the statute of limitations, taxpayers need retain only the records necessary to compute subsequent years' LIFO calculations.

Further, the filing of Form 3115, Application for Change in Accounting Method, to change a LIFO method is a prospective change with no Sec. 481 adjustment. As such, the IRS does not normally review prior layers or the related documentation; those layers are "locked in." Therefore, if a taxpayer is unsure if its election is valid or if the documentation is sufficient, filing Form 3115 may afford some audit protection. However, proper recordkeeping is still always the best defense.

From Louis J. Miller, CPA, South Bend, IN

©1999 AICPA