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In SEC FRP 205, the SEC cautioned registrants against the use of certain misleading accounting techniques that conflict with the conceptual application of the LIFO method.

3.9.1 Incorporating new items into LIFO calculations

One common problem in LIFO application involves determining whether items are “new items.” This is because the accounting for inventory added into the LIFO pools is different for new items and existing inventory. Financial results can vary significantly depending on how new items are defined and the computation methodology used to incorporate them into the LIFO calculations (e.g., the pricing index can become distorted if the current cost of the item is used as the base year cost). Neither GAAP nor IRS regulations or rules contain a specific definition of “new items,” and, over time, some interpretations have been challenged by both the SEC and the IRS. In general, items should not be considered new items simply because of insignificant or arbitrary differences in attributes (e.g., slight differences in chemical composition, changes in manufacturing or production line location, or differences in supply sources). The FinREC LIFO guidance provides the following additional guidance that may be used to identify a new inventory item:
  • It should be “a raw material, product, or cost component not previously present in significant quantities in inventory.”
  • It “should not be commingled physically with other materials or products so that its identity is lost and it should be accounted for separately.”
  • It “should have qualities (physical, chemical, or both) significantly different from those of previously inventoried items.”
  • It should not be “treated as fungible with items already in the pool.”
  • “Changes in the market value of an item or merely purchasing a virtually identical item from a different supplier does not make the item a new item.”
When adding new items to a pool, the FinREC LIFO guidance recommends that the base-year cost be reconstructed. This is consistent with the concern expressed in SAB Topic 5.L that “when the effects of inflation on the cost of new products are measured by making a comparison with current cost as the base-year cost, rather than a reconstructed base-year cost, income is improperly increased.” If the base-year cost of a new item is not objectively determinable, the FinREC guidance says it should be estimated “based on the most objectively determinable sources available, such as (in order of objectivity): published vendor price lists, vendor quotes, and general industry indexes.”
A lot of new items with an aggregate current cost that is a significant portion of the entire LIFO inventory could result in a material difference in the ending LIFO carrying amount if the current cost is used rather than the reconstructed base-year cost (i.e., current year inflation or cumulative inflation relative to the base year would be understated). Generally, in a period of rising prices, the failure to reconstruct base-year costs produces a higher inventory amount, presumably a higher tax bill, and higher reported net income. In addition, even if the effect of using current cost for new items in any given year may not be material in a single year, the cumulative effect of such a practice may be significant and is inconsistent with the LIFO principle.
Generally, the reconstructed base-year cost should be used to price new items added to existing LIFO pools. However, in certain limited circumstances it may be acceptable to value new items added to an existing pool at current-year cost. The use of current-year cost to price new items added to an existing pool may be appropriate if (1) the new items are clearly not similar to existing items in the pool and (2) the use of current-year cost does not distort the index that applies to other items in the pool. The use of the link-chain method or the substitute base-year approach would avoid such a distortion.
Section 4 of the FinREC LIFO guidance illustrates the difference in computed LIFO value if current-year cost, rather than reconstructed base-year cost, is used for a new item.
Reconstructing base-year costs may become more difficult the longer dollar-value LIFO is used. One way of minimizing this difficulty is to use the link-chain method to determine the price change for the year. Under the link-chain method, items in closing inventory are valued at prior year costs (rather than base-year costs) and current year costs are used to derive the current year’s index. This index is then linked to the cumulative index for the preceding year. The FinREC LIFO guidance notes that “if the link chain technique is used, reconstruction of prior years’ costs is unnecessary because that technique produces approximately the same results as reconstruction.”
A company that has applied LIFO for a long time may sometimes find it impractical, if not impossible, to reconstruct base-year costs of items previously reported on a non-LIFO basis. Under the substitute base-year approach described in the FinREC LIFO guidance, beginning-of-the-year costs for some year after the original base year, rather than the original base-year costs, are used to determine changes in dollar-value LIFO pools. Prior layers are retained, but the indices are expressed as a percentage of costs of the substitute base year. Under this approach, new items are priced at current-year costs rather than at reconstructed base-year costs. The IRS permits companies to use the substitute base-year approach in many circumstances. Similarly, the FinREC LIFO guidance concludes that “a company may use the substitute base-year technique for financial reporting purposes.”

3.9.2 LIFO transfer of inventory within a consolidated group

Inventory may transfer between LIFO pools or from a LIFO pool to inventory accounted for at FIFO, either within a company or between subsidiaries or divisions of a reporting entity. These intercompany transfers can be particularly complex if a LIFO inventory liquidation has occurred during the year in any of the transferring LIFO pools. ASC 810‑10‑10‑1 provides a reminder concerning the premise of consolidated financial statements.

Excerpt from ASC 810-10-10-1

The purpose of consolidated financial statements is to present…the results of operations and the financial position of a parent and all its subsidiaries as if the consolidated group were a single economic entity.

Consistent with the premise in ASC 810-10-10-1, under ASC 810-10-55-2 through ASC 810-10-55-4, intra-entity profit or loss on assets remaining within the consolidated group should be eliminated. Results of operations and financial position, therefore, should not be affected by inventory transfers within a reporting entity, including transfers with investments accounted for using the equity method. Inventory transferred between or from LIFO pools may cause LIFO inventory liquidations, which could affect the amount of intercompany profit to be eliminated. Many different approaches are used by entities to eliminate such profit. Each reporting entity should adopt an approach that, if consistently applied, defers reporting intercompany profits from transfers within a reporting entity until such profits are realized by the reporting entity through dispositions outside the consolidated group. The approach should be suited to the entity’s individual circumstances.
There is diversity in the accounting for unrealized LIFO liquidation profit. Some companies continue to consider the profit to be unrealized as long as the ending inventory of the reporting entity (whether it is the inventory of the consolidated group or at an entity accounted for using the equity method) is equal to or greater than the prior year’s inventory. Other companies follow the inventory method of the receiving pool. For example, if the receiving pool uses FIFO, the profit would be realized when the inventory is sold and would not be eliminated in consolidation or in equity method accounting. In the absence of any authoritative literature, either is acceptable, but companies should apply the selected approach consistently.
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