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:

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.”