Base-year updates can improve quality of LIFO calculations, yet are hard to come by.

Many taxpayers continue to use the last-in, first-out (LIFO) method of accounting to determine the cost of their inventory. This method of accounting assumes that the goods most recently purchased or produced are the first goods sold and, accordingly, that their associated costs are the first costs treated as costs of sale, Thus, inventory basis is built up in layers over time as ending inventories periodically increase over beginning inventories. The accounting theory supporting LIFO is the belief that it provides a better matching of current costs with current revenues, thereby eliminating inventory profits from the taxpayer's earnings. In this way, businesses are able to reinvest their profits in inventory in an economically efficient manner.

Dollar-Value LIFO

Most LIFO taxpayers employ the dollar-value method as their overall LIFO method (as opposed to the specific-goods LIFO method). Unlike the specific-goods method (which measures inventory increases or decreases based solely on quantity changes of specific items), the dollar-value method measures inventory increases and decreases using base-year dollars as the unit of quantity measure, Under dollar-value LIFO, a number of related inventory items are grouped into a pool. Whether inventory of the pool increased or decreased for the tax year is based on the aggregate change in base-year dollars of all of the items within the pool, Indeed, the proper measurement of whether inventory increased or decreased from the beginning of the year is critical to clearly reflect income under the dollar-value method.

At the center of a dollar-value LIFO calculation using the double extension method is the requirement that all items in ending inventory be revalued at their respective base-year costs. A base-year cost represents an item's costs that were or would have been in effect at the beginning of the base year, which generally is the year LIFO was adopted. Each year-end, the taxpayer's inventory valued using base-year costs must be compared to its prior year-end inventory valued using the same base-year costs, in order to determine whether the taxpayer experienced a true increase (increment) or decrease (decrement) of inventory within the pool.

An increment is then revalued to its current cost, and constitutes a new layer added to the carrying value of the taxpayer's inventory. Decrements are subtracted from the built-up inventory history in reverse chronological order. As might be expected, it is critical that each inventory item's base-year cost be determined as accurately as possible, to ensure that a pool's increments and decrements (which have a direct impact on the inventory's carrying value) are computed accurately. It is readily apparent that the integrity of the base-year costs used as a measure of quantity is crucial to clearly reflect income.

Reconstruction of Base-Year

Costs

Each item that is first included in inventory in a year subsequent to the base year must have a base-year cost determined (i.e., reconstructed). The reconstruction of an item's base-year cost can become a difficult process if the item did not exist in the base year. In recognition of the fact that the determination of base-year costs in comparable price levels is so important, the regulations under Sec. 472 permit taxpayers to use reasonable means to determine what the cost of the item would have been had it been in existence in the base year. However, those regulations also state that, if the taxpayer cannot adequately reconstruct the base-year cost of an item, its current-year cost will be deemed to be its base-year cost. The result can be particularly onerous if the item's current cost significantly exceeds its projected base-year cost, as this leads to an overstated increment to the pool and, therefore, to an overstatement of taxable income.

Permissibility of a Base-Year

Update

Because of this potential distortion, taxpayers favor a procedure by which they are permitted periodically to update their base year and use the costs attributable to such year (while retaining the carrying value of all prior-year layers within the inventory pool). Many taxpayers find that, over time, they add new items which did not exist in the base year. Taxpayers believe that, as this change in business occurs, the original base year becomes less relevant. By continuing to use the original base year to determine increments and decrements, taxpayers are forced to rely on reconstruction estimates, rather than actual data. The longer the period of reconstruction, the more likely potential errors will arise.

The IRS previously has considered allowing taxpayers to periodically update their base year, say, once every 10 years. However, the Service generally will allow base-year updates only under certain circumstances when mandated under either the Sec. 263A or Sec. 472 regulations. Therefore, it is important that taxpayers be aware of the following situations to know when base-year updates have been permitted:

* Cost capitalization changes under Sec. 263A: Taxpayers may change either the costs they treat as inventoriable or the method by which they allocate indirect costs to inventory items. To receive consent to make these changes, LIFO taxpayers are required to revalue their existing LIFO layers and recognize a Sec. 481(a) adjustment. Taxpayers may revalue their layers by using the three-year average method under Temp. Regs. Sec. 1.263A-7T(e)(6)(iv). When that method is used, a base-year update is required.

* Change to link-chain method: Under this method, the base-year cost of an item always is its cost from the preceding year. Changes to link-chain are accompanied by an updated base year.

* Other instances of a base-year update: Taxpayers that switch from the components of cost method to the total product cost method to determine base-year costs have been granted base-year updates. In addition, merging taxpayers that integrate their LIFO pools, when other than just the double extension method is used, have obtained a base-year update.

Final Note

Use of an updated base year permits the most accurate measurement of prospective increments and decrements and, therefore, results in the clearest reflection of income for years after the update. However, the process of updating a base year is considered an accounting method change to which the IRS National Office must first consent. Although the Service continues to take the position that taxpayers should not be permitted periodic base-year updates, it generally has recognized the practicality and permissibility of such an update when confronted with situations such as those previously described.