Taking the complexity out of simplified LIFO.There's good news for companies seeking practical and cost-effective cost-effective, n the minimal expenditure of dollars, time, and other elements necessary to achieve the health care result deemed necessary and appropriate. ways to deal with the difficulties of Lifo accounting. The IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. has proposed changes that would allow simplified sim·pli·fy tr.v. sim·pli·fied, sim·pli·fy·ing, sim·pli·fies To make simple or simpler, as: a. To reduce in complexity or extent. b. To reduce to fundamental parts. c. Lifo to live up to its name for companies that operate with relatively high and volatile With regard to computer memory, it means "temporary" and not "highly changeable," which is the usual meaning of the word. See volatile memory. 1. (programming) volatile - volatile variable. 2. (storage) volatile - See non-volatile storage. gross margin percentages. Outlined in IRS Bulletin 2000-23 (June June: see month. 5, 2000), the proposed changes provide taxpayers an opportunity to directly use published price indexes without having to convert them to cost indexes. This will further simplify Lifo and eliminate some potentially adverse tax consequences. A MIXED BLESSING mixed blessing Noun an event or situation with both advantages and disadvantages mixed blessing n it's a mixed blessing → tiene su lado bueno y su lado malo Several years ago, when a client adopted the simplified Lifo inventory price index computation Computation is a general term for any type of information processing that can be represented mathematically. This includes phenomena ranging from simple calculations to human thinking. (IPIC IPIC Intellectual Property Institute of Canada IPIC Indianapolis Private Industry Council IPIC International Petroleum Investment Co (Abu Dhabi) IPIC Inventory Price Index Computation IPIC Information Processing Interagency Conference ) method of accounting for inventory (see glossary A term used by Microsoft Word and adopted by other word processors for the list of shorthand, keyboard macros created by a particular user. See glossaries in this publication and The Computer Glossary. of terms on page 68), as originally established under Treasury regulations section 1.472-8(e)(3), the election turned out to be a mixed blessing. On the positive side, it substantially lowered the client's administration costs and eliminated the headaches tradition ally associated with Lifo computations. The client also benefited from being able to monitor the potential tax impact of changing prices throughout the year because the Bureau of Labor Statistics Bureau of Labor Statistics (BLS) A research agency of the U.S. Department of Labor; it compiles statistics on hours of work, average hourly earnings, employment and unemployment, consumer prices and many other variables. (BLS See Bureau of Labor Statistics. ) publishes the relevant price indexes monthly. But the client also experienced some fairly adverse tax consequences. The IRS has historically required taxpayers to convert a published price index to a cost index because a price index relates more to the selling prices of goods than to the cost of goods sold Cost of goods sold The total cost of buying raw materials, and paying for all the factors that go into producing finished goods. cost of goods sold . In making these conversions, year-to-year variations in gross profit produced some unwelcome increases in taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. computed on a Lifo basis, catching the company and its auditors AUDITORS, practice. Persons lawfully appointed to examine and digest accounts referred to them, take down the evidence in writing, which may be lawfully offered in relation to such accounts, and prepare materials on which a decree or judgment may be made; and to report the whole, together by surprise. In retrospect, the election has not turned out to be as advantageous as the client originally hoped. With the proposed changes in IRS regulations however, the simplified Lifo IPIC method stands to become an excellent election for a host of for-profit for-prof·it adj. Established or operated with the intention of making a profit: a for-profit organization. businesses. CHOICES, CHOICES In computing computing - computer the cost of goods sold and valuing inventories, CPAs have always faced the dilemma Dilemma Buridan’s ass placed exactly between two equal haystacks, could not decide which to turn to in his hunger. [Fr. Philos.: Brewer Dictionary, 154] of choosing from several possible costs to value units of inventory accumulated ac·cu·mu·late v. ac·cu·mu·lat·ed, ac·cu·mu·lat·ing, ac·cu·mu·lates v.tr. To gather or pile up; amass. See Synonyms at gather. v.intr. To mount up; increase. at various points over time. GAAP GAAP See: Generally Accepted Accounting Principles GAAP See generally accepted accounting principles (GAAP). requires that such choices be systematic and rational. In response, accountants have invoked a particular assumption about the flow of costs. For instance, Fifo assumes the first costs in are the first costs out. Under Fifo, the first costs in are included in cost of goods sold and matched against the period's revenues. A company uses the more recent inventory costs (last-in) to value any ending inventory that remains on hand. In contrast, Lifo assumes the last costs in are the ones a company should use to measure the cost of goods sold, leaving the earliest costs to value ending inventory. Lifo offers the company the benefit of reporting lower taxable income in times of inflation. It also has the theoretical advantage of matching more current costs (those last-in) with current revenues. But a business must weigh these benefits against some of the operational difficulties of accounting for inventory on a Lifo basis. If a taxpayer opts for the double extension Lifo method, one difficulty it faces stems from having to retain antiquated files of base year costs for all inventory items. The double extension method also presents CPAs with the challenge of having to deal with new products that did not exist in the base year inventory. Finding suitable comparable products becomes increasingly difficult as you move further away from the year of adoption. Companies could always avoid problems with the double extension method by adopting the link-chain index method. But developing an appropriate index could also be costly and complicated. Recognizing the burdens and complexities of existing Lifo methods, the IRS provided relief in 1981 when it introduced the simplified Lifo (IPIC) method. Instead of having to maintain base year cost records or invest resources in developing their own cost indexes, taxpayers could use the BLS's monthly price indexes. But they then had to convert the relevant price index into a company-specific cost index by using their own gross margin experience to develop the cost complement (1 minus gross margin percentage) of the published index. Small businesses (those with average annual gross receipts the total of the receipts, before they are diminished by any deduction, as for expenses; - distinguished from net profits. - Bouvier. See under Gross, a. os> See also: Gross Receipt of $5 million or less for the three preceding tax years) are allowed to rise 100% of the reported price change. All others are restricted to using 80% of the reported change. For some, these restrictions are a small price to pay for the relative ease and certainty CERTAINTY, UNCERTAINTY, contracts. In matters of obligation, a thing is certain, when its essence, quality, and quantity, are described, distinctly set forth, Dig. 12, 1, 6. It is uncertain, when the description is not that of one individual object, but designates only the kind. Louis. of using a reported index. THE PREDICTABLE SIDE OF SIMPLIFIED LIFO A distinct advantage of simplified Lifo is it can produce a highly predictable Lifo adjustment, avoiding troublesome yearend surprises. Higher predictability also enhances quarterly financial reporting and promotes greater precision in making estimated tax Federal and state tax laws require a quarterly payment of estimated taxes due from corporations, trusts, estates, non-wage employees, and wage employees with income not subject to withholding. deposits. Because the BLS reports the price indexes monthly (generally within three weeks of month end) CPAs can keep an eye on inflation's impact on Lifo throughout the year. CPAs can easily access the indexes via the Internet Internet Publicly accessible computer network connecting many smaller networks from around the world. It grew out of a U.S. Defense Department program called ARPANET (Advanced Research Projects Agency Network), established in 1969 with connections between computers at the at stats.bls.gov/blshome.htm. When a business uses simplified Lifo, the Lifo effect and subsequent adjustment is merely the allowable percentage change in the index multiplied mul·ti·ply 1 v. mul·ti·plied, mul·ti·ply·ing, mul·ti·plies v.tr. 1. To increase the amount, number, or degree of. 2. Mathematics To perform multiplication on. by the Fifo value of the prior year's ending inventory. Exhibit 1, below, illustrates this for both small and large companies using the old rules that require a cost complement adjustment. If the cost adjusted index shows 10% inflation, then the Lifo adjustment is 10% of the Fifo value of the prior year's ending inventory. Exhibit 1 assumes an annual inflation rate of 10%, a constant cost complement percentage of 60% (1 minus gross margin percentage of 40%) and no real increase in the physical amount of the inventory.
Exhibit 1: The Predictable Side of Lifo
(Old rules: Price index adjusted to cost index)
Small companies
(*)Year 20X1 Year 20X2
Price index 100 110
Cost complement % 3.60 3.60
Firm specific cost index 60 66
Annual inflation index = 66/60 = 1.1 1.1
Annual inflation index = 72.6/66 = 1.1
Allowable annual inflation
(100% small; 80% large companies) n/a(**) 10%
Fifo value of inventory $10,000 $11,000
Divided by allowable cumulative inflation
index 1.0 1.1
Inventory at base year cost $10,000 $10,000
Increment (decrement) in base year $'s
Increment X relevant index
Lifo increment (decrement)
Lifo value of ending inventory $10,000 $10,000
Addition to Lifo Reserve n/a $1,000
Required Lifo adjustment as a % of
prior year's Fifo inventory value n/a 10%
Small Large
Companies companies
Year 20X3 (*)Year 20X1
Price index 121 100
Cost complement % 3.60 3.60
Firm specific cost index 72.60 60
Annual inflation index = 66/60 = 1.1
Annual inflation index = 72.6/66 = 1.1 1.1
Allowable annual inflation
(100% small; 80% large companies) 10% n/a
Fifo value of inventory $12,100 $10,000
Divided by allowable cumulative inflation
index 1.21 1.0
Inventory at base year cost $10,000 $10,000
Increment (decrement) in base year $'s
Increment X relevant index
Lifo increment (decrement)
Lifo value of ending inventory $10,000 $10,000
Addition to Lifo Reserve $1,100 n/a
Required Lifo adjustment as a % of
prior year's Fifo inventory value 10% n/a
Large companies
Year 20X2 Year 20X3
Price index 110 121
Cost complement % 3.60 3.60
Firm specific cost index 66 72.60
Annual inflation index = 66/60 = 1.1 1.1
Annual inflation index = 72.6/66 = 1.1 1.1
Allowable annual inflation
(100% small; 80% large companies) 8% 8%
Fifo value of inventory $11,000 $12,100
Divided by allowable cumulative inflation
index 1.08 1.1664
Inventory at base year cost $10,185 $10,374
Increment (decrement) in base year $'s $185 $189
Increment X relevant index 3 1.08 3 1.1664
Lifo increment (decrement) $200 $220
Lifo value of ending inventory $10,200 $10,420
Addition to Lifo Reserve $800 $880
Required Lifo adjustment as a % of
prior year's Fifo inventory value 8% 8%
(*) 20X1 year of adoption.
(**) Not applicable because 2001 is considered the base year against
which all future inflation is measured.
For the small company example in exhibit 1 the Lifo adjustment in year 20X2 is $1,000--10% of year 20X1's $10,000 ending inventory Fifo value. The adjustment in year 20X3 is $1,100--10% of year 20X2's ending inventory Fifo value. The same relationship can be seen in exhibit 1's large company example. Even though inventory did not really increase, the same facts produced an increment To add a number to another number. Incrementing a counter means adding 1 to its current value. for the large company (limited to using 80% of the inflation adjustment) and no increment for the small company. In either situation, using simplified Lifo produces a Lifo adjustment equal to the annual allowable inflation in the cost index times the prior year's ending Fifo inventory value. This will be true whenever inventories are constant or show an increment. (It will not necessarily be true if they decrease.) THE PROBLEM OF COST COMPLEMENT ADJUSTMENTS So far, we have only considered changes in the price index, with gross margin and cost complement percentages treated as constants. But any change in a company's gross profit percentage from year to year will have an impact on the size of the Lifo expense when the price index is adjusted to a cost complement index. A decrease in gross profit percentage will result in a greater measure of inflation and produce a larger Lifo adjustment than if the gross margin had remained the same as the previous year. The converse (logic) converse - The truth of a proposition of the form A => B and its converse B => A are shown in the following truth table: A B | A => B B => A ------+---------------- f f | t t f t | t f t f | f t t t | t t would be true of an increase in the gross profit percentage because the larger gross profit, when backed out of the price index, would result in a smaller cost index and consequently less inflation. Adjusting price indexes to cost indexes works best for companies engaged in activities such as wholesaling, which typically experience high volume and consistently low gross margins. But cost-adjusted price index methods are problematic for businesses with high and variable gross margins. These companies typically have heavy fixed costs fixed costs, n.pl the costs that do not change to meet fluctuations in enrollment or in use of services (e.g., salaries, rent, business license fees, and depreciation). associated with inventory and thus experience significant variations in average unit costs arising from swings in production volume. This makes it difficult to calculate an accurate gross margin percentage on an interim basis. The company does not know the true gross margin for the year until it takes a physical inventory in conjunction conjunction, in astronomy conjunction, in astronomy, alignment of two celestial bodies as seen from the earth. Conjunction of the moon and the planets is often determined by reference to the sun. with a timely and accurate sales and accounts payable cutoff. Even though the relevant published price index is readily available, predicting the actual yearend Lifo expense is still not possible without knowing the actual cost complement adjustment. Thus any predictive benefit from regularly published price indexes is lost. But more important, for. taxpayers with typically high margins, relatively small swings in the gross margin percentage can greatly distort the reported Lifo expense calculation when a price index must be adjusted to its cost complement. Exhibit 2, below, uses the old rules and compares a company with high margins to one with relatively low margins to show how a similar three-point swing in a gross profit margin Gross profit margin Gross profit divided by sales, which is equal to each sales dollar left over after paying for the cost of goods sold. gross profit margin A measure calculated by dividing gross profit by net sales. produces very different Lifo adjustments. The price index is assumed to be constant over the three years to highlight the impact of the changing cost complement percentage.
Exhibit 2: Cost Complement Changes--High and Low Margin Companies
(Old rules: Price index adjusted to cost index)
High margin company
(*)Year 20X1 Year 20X2
Price index 100 100
Cost complement % 0.40 0.43
Company specific cost index 40 43
Annual inflation index = 20X2
cost index / 20X1 cost index 1.0750
Annual inflation index = 20X3
cost index / 20X2 cost index
Allowable annual inflation index (100%) 1.0000 1.0750
Cumulative inflation index 1.0 1.0750
Fifo value of inventory $10,000 $12,000
Divided by allowable cumulative
inflation index 1.0 1.0750
Inventory at base year cost $10,000 $11,163
Increment(decrement) in base year $'s $1,163
(Increment) 3 (relevant index) 1.0750
Lifo increment (decrement) 1,250
Lifo value of ending inventory $10,000 $11,250
Addition (deduction) to/(from) Lifo
reserve n/a(**) $750
Required Lifo adjustment as a % of
prior year's
Fifo inventory value n/a 7.5%
High margin Low margin
company company
Year 20X3 (*)Year 20X1
Price index 100 100
Cost complement % 0.40 0.80
Company specific cost index 40 80
Annual inflation index = 20X2
cost index / 20X1 cost index
Annual inflation index = 20X3
cost index / 20X2 cost index 0.9302
Allowable annual inflation index (100%) 0.9302 1.0000
Cumulative inflation index 1.0000 1.0
Fifo value of inventory $13,000 $10,000
Divided by allowable cumulative
inflation index 1.0000 1.0
Inventory at base year cost $13,000 $10,000
Increment(decrement) in base year $'s $1,838
(Increment) 3 (relevant index) 1.0000
Lifo increment (decrement) 1,838
Lifo value of ending inventory $13,088 $10,000
Addition (deduction) to/(from) Lifo
reserve ($838) n/a
Required Lifo adjustment as a % of
prior year's
Fifo inventory value 27.0% n/a
Low margin company
Year 20X2 Year 20X3
Price index 100 100
Cost complement % 0.83 0.80
Company specific cost index 83 80
Annual inflation index = 20X2
cost index / 20X1 cost index 1.0375
Annual inflation index = 20X3
cost index / 20X2 cost index 0.9639
Allowable annual inflation index (100%) 1.0375 0.9639
Cumulative inflation index 1.0375 1.0000
Fifo value of inventory $12,000 $13,000
Divided by allowable cumulative
inflation index 1.0375 1.0000
Inventory at base year cost $11,566 $12,999
Increment(decrement) in base year $'s $1,566 $1,433
(Increment) 3 (relevant index) 1.0375 1.0000
Lifo increment (decrement) 1,625 1,433
Lifo value of ending inventory $11,625 $13,058
Addition (deduction) to/(from) Lifo
reserve $375 ($433)
Required Lifo adjustment as a % of
prior year's
Fifo inventory value 3.8% 23.6%
(*) 20X1 year of adoption.
(**) Not applicable because 2001 is considered the base year against
which all future inflation is measured.
When the high margin company experiences a three-point dip dip, in agriculture, method of treating animals (chiefly livestock) infested with skin parasites such as mites, ticks, and warbles. The animal is dipped into or forced to swim through a tank filled with an insecticide solution. in its gross margin percentage, resulting in a corresponding three-point increase in its cost compliment Not to be confused with Complement. Compliment may be
v. 1. To return to a former condition, practice, subject, or belief. 2. To undergo genetic reversion. back to where they were at the outset. The high margin company shows over twice as much income created by the Lifo adjustment as does the low margin company. These year-to-year swings in the Lifo adjustment are generally unwelcome. Keeping a watchful watch·ful adj. 1. Closely observant or alert; vigilant: kept a watchful eye on the clock. See Synonyms at aware, careful. 2. Archaic Not sleeping; awake. eye on the monthly price index would most likely have lulled a taxpayer into thinking there would be no Lifo effect at all because there was no visible sign of either inflation or deflation deflation: see inflation. deflation Contraction in the volume of available money or credit that results in a general decline in prices. A less extreme condition is known as disinflation. . But if there was a resulting change in gross profit margins, taxpayers could have quite a surprise on their hands. As exhibit 2 shows, the surprise could go either way, and would affect high margin companies more than low margin companies. A SIMPLER CALCULATION Lifo calculations using published price indexes become easier and more predictable when CPAs can use price indexes directly. Exhibit 3, above, shows how to calculate the Lifo adjustment without having to resort to an adjusted cost index. The example illustrates a small company experiencing 10% annual inflation in selling prices and increasing levels of inventory in the second and third years.
Exhibit 3: Simplified Lifo Using New Rules--Small Companies
Year (1) (2) (3) (4)
Fifo value Price index Inventory Increment
of inventory restated to in base
base year year (20X1)
(20X1) dollars dollars
(1)/(2)
20X1 $10,000 1.00 $10,000 n/a
20X2 $12,000 1.10 $10,909 $909
20X3 $14,000 1.21 $11,570 $661
Year (5) (6) (7) (8)
Lifo value of Lifo value Required Lifo Required
increment of inventory reserve Lifo
(4)3(2) (1)-(6) adjustment
(7)t11 2(7)t
20X1 n/a $10,000 0 n/a
20X2 $1000 $11,000 $1000 $1,000
20X3 $800 $11,800 $2200 $1,200
Note that the yearend Lifo adjustment equals the annual inflation rate (10%) times the beginning Fifo value of the inventory. This will be the case whenever a company experiences an increase in inventory. As a result, the annual Lifo adjustment becomes quite predictable. AN END TO VOLATILITY Volatility 1. A statistical measure of the tendency of a market or security to rise or fall sharply within a period of time. 2. A variable in option pricing formulas that denotes the extent to which the return of the underlying asset will fluctuate between now and the The proposed changes in IRS Bulletin 2000-23 eliminate the required cost complement adjustment and bring welcome simplification sim·pli·fy tr.v. sim·pli·fied, sim·pli·fy·ing, sim·pli·fies To make simple or simpler, as: a. To reduce in complexity or extent. b. To reduce to fundamental parts. c. to the IPIC method of accounting for inventory on a Lifo basis. This enhances the taxpayers' ability to predict the yearend Lifo adjustment. More important, the simplification eliminates the unwelcome volatility in Lifo expense created when high margin businesses experience even slight changes in gross margin percentages. CPAs can recommend employers and clients adopt the IPIC method with confidence that it will result in a more highly predictable outcome and greatly reduce the administrative and computational Having to do with calculations. Something that is "highly computational" requires a large number of calculations. burdens of traditional double extension and link-chain Lifo. Help from the IRS The following guidance is available at www.irs.gov See .gov and GovNet. (networking) gov - The top-level domain for US government bodies. . * Publication 538, Accounting Periods and Methods. * Form 970, Application to Use Lifo Inventory Method. * Form 3115, Application for Change in Accounting Methods. EXECUTIVE SUMMARY * THE IRS HAS PROPOSED CHANGES THAT WOULD ALLOW simplified Lifo to live up to its name for companies that operate with relatively high and volatile gross margin percentages. The changes, outlined in IRS Bulletin 2000-23, allow taxpayers to use public price indexes without having to convert them to cost indexes. * COMPANIES THAT HAD ADOPTED THE SIMPLIFIED LIFO IPIC method of accounting for inventory found the election a mixed blessing. Converting a published price index to a cost index resulted in some unwelcome increases in taxable income as a result of year-to-year variations in gross profit. * WHILE THE 1981 INTRODUCTION OF THE SIMPLIFIED LIFO IPIC method helped some companies by producing a highly predictable Lifo adjustment, cost-adjusted price indexes are problematic for businesses with high and variable gross margins. Although published price indexes are readily available, it's it's 1. Contraction of it is. 2. Contraction of it has. See Usage Note at its. it's it is or it has it's be ~have not possible for companies to predict the actual yearend Lifo expense without knowing the actual cost complement adjustment. * SIMPLIFIED LIFO CALCULATIONS WILL BECOME EASIER and more predictable now that companies can use price indexes directly. As a result CPAs can recommend that employers and clients adopt the IPIC method with confidence they can realize the administrative and computational benefits without unnecessary variations. BRUCE Bruce, Scottish royal family descended from an 11th-century Norman duke, Robert de Brus. He aided William I in his conquest of England (1066) and was given lands in England. HOWARD, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , PhD, is professor of accounting and chair of the department of business and economics at Wheaton College Wheaton College may refer to:
1 City (1990 pop. 51,464), seat of Du Page co., NE Ill., a residential suburb of Chicago; inc. 1859. It is a religious center and the headquarters of the Theosophical Society of America. Many evangelical organizations are also based there. , Illinois Illinois, river, United States Illinois, river, 273 mi (439 km) long, formed by the confluence of the Des Plaines and Kankakee rivers, NE Ill., and flowing SW to the Mississippi at Grafton, Ill. It is an important commercial and recreational waterway. . He also maintains a private accounting practice. His e-mail address See Internet address. e-mail address - electronic mail address is bruce.howard@wheaton.edu See .edu. (networking) edu - ("education") The top-level domain for educational establishments in the USA (and some other countries). E.g. "mit.edu". The UK equivalent is "ac.uk". . |
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