Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board

Chapter 7
LIFO Background
Overview of the Method
A large problem area concerning the examination of auto dealerships occurs where the LIFO
method of inventory valuation is used. This has been a problem due to the technical complexity
of the method coupled with the volumes of records that must be examined to determine whether
there is compliance.
If LIFO is such a complex method of accounting, why do auto dealerships elect it? The benefits
offered by the method outweigh the negative aspects of its use for most. During inflationary
times taxes are deferred by changing the flow of costing inventory through a sequence of
valuation steps.
The last costs incurred are placed into the cost of sales and the earliest costs are retained as
inventory (layers). This means units in ending inventory are valued at the oldest unit costs
available and units in cost of goods sold are valued at the newest unit costs available.
Accordingly, the LIFO method of valuation reverses the normal (assumed) flow of costs reflected
in the FIFO (cost) method. LIFO is merely removing inflation from ending inventory and
expensing it as part of the cost of goods sold.
When comparing the flow of LIFO costs to the flow of FIFO costs, we see that FIFO charges the
cost of inventory items to cost of sales in the order of their acquisition. The cost of the inventory
on the balance sheet under the FIFO method more clearly reflects the replacement cost than does
the LIFO method. Under the FIFO method, when inventory is sold and then replaced at a higher
cost, the difference between the inventories’ selling price and the replacement cost, FIFO,
recognizes a phantom profit and fails in an economic sense to provide the best matching of costs
and revenues.
The LIFO approach attempts to match the most recent costs of purchases from the computation
of inventory costs. Where LIFO is used, if prices increase, a deferral of taxes will result and
profits are decreased. The later higher costs are charged to costs of sales and earlier lower costs
remain in inventory. This means inventory costs are removed in the reverse order of their
acquisition.
The difference between the LIFO and non-LIFO inventory values is called the LIFO Reserve.
The LIFO reserve represents the inflation that has been deducted through increasing Cost of
Goods Sold which results in lower taxes. It is important to note that the reserve must be brought
back into income at some future date. The reserve is only a temporary deferral, not a permanent
one; a timing difference. To better understand LIFO concepts, see, Amity Leather Products Co.
v. Commissioner, 82 T.C. 726 (1984), Hamilton Industries, Inc., Successor of Mayline
Company, Inc. and Subsidiary v. Commissioner, 97 T.C. 120 (1991), and Fox Chevrolet, Inc.
(Maryland) v. Commissioner, 76 T.C. 708 (1981).
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