The Last Shall Be First

It's that time of year when dealers hold their breath in fear of LIFO, the Last-In, First-Out inventory valuation method. Some dealers fear it, many don't fully grasp it.

LIFO is not something exclusive to auto dealers but is used in many other inventory-intensive industries as well.

LIFO is one of several inventory valuation options. It's generally income-tax friendly during times of growing inventories and inflation.

It's an outgrowth of the “base stock method” which started in England during the 1800s. “Base stock” was considered a permanent investment. Any change in its value was ignored. Any goods sold were considered to have come from quantities sold over and above the base stock.

Accountants didn't conceive the base stock method. Rather, businessmen did responding to tax pressures and such.

In 1903, the American Smelting and Refining Company became the first U.S company to adopt the base stock method. Years later in 1919, the U.S. Treasury Department prohibited the base stock method for use in computing federal income taxes.

In 1930, the Supreme Court also ruled against the base stock method in computing income taxes. That court decision sealed the fate of the base stock method. After this disallowance, a search for a suitable alternative to the base stock method began. The acceptance of LIFO by professional groups and Congress in 1938 and 1939 began the early development of LIFO.

In 1938, LIFO was approved for certain raw materials of tanners, brass smelters and refiners. It was considered unfair that only these few industries were covered. In response, Congress appointed a committee to rewrite the tax law relating to LIFO. It was included in the Revenue Act of 1939.

The quality of the 1939 act may be judged by the fact that, except for some industry specific clarifications, it has continued in the Internal Revenue Code without material changes to the present day.

As far as automobile dealers were concerned, LIFO lay dormant for almost 35 years after the law allowed it. However, in the early 1970's, when price increases on new automobiles and parts were in double-digits, it became apparent that much of a dealer's profits were being tied up in inventories. Dealers had a tough time paying the income taxes on their profits. The adoption of LIFO was generally a viable solution to this dilemma.

LIFO does not change day-to-day accounting methods. An adjustment to profit must be made on annual statements; i.e. the December operating report that the auto makers, captive finance companies, banks and stockholders receive.

LIFO calculations for automobile dealerships have become very specialized. There are now industry-specific guidelines for new vehicles, used vehicles and parts.

For those that do not deal with dealership LIFO on a daily basis these rules can be overwhelming. Generally, there are two reasons some automobile dealerships are not using LIFO:

In performing LIFO calculations, sometimes we work directly for the dealership and other times we work directly for the dealership's CPA firm. The questions that we get from each reinforce the ever-increasing complexity of what started as a simple “base stock” computation. Breath easier. If understood, LIFO is nothing to fear. Rather, it's something to embrace.

Don Ray is a Senior Member of the George B. Jones Dealer Services division of Dixon Odom PLLC, a national accounting and consulting group for automobile dealers. He's at 901-684-5643