The cost method of accounting requires inventory to be valued at its acquisition cost. Acquisition cost includes all of the costs associated with taking possession of merchandise. The cost should be reduced for trade discounts received. Cash discounts (for early payment of invoice) may be deducted or not deducted at the taxpayer’s option as long as the method is consistent. Retailers must also add to the value of the inventory the Uniform Capitalization cost allocation determined under IRC section 263A unless they meet the $10,000,000 or less gross receipts exceptions of IRC section 263A(b)(2)(B), described in IRM 4.43.1.3.4.

When a retailer using the cost method takes an inventory count, the goods on hand must be matched against or traced to the stock ledger to determine the cost. Because of the recordkeeping requirements involved, most retailers have elected the retail method which does not require such tracing. With the advances in computers, bar codes, and POS terminals, the retailer now has the capability to use the cost method with little or no increased record keeping costs.

In associating costs with the physical inventory, the taxpayer may use specific identification or may adopt an accounting assumption.

Most taxpayers use the lower of cost or market method (LCM) since there are advantages to using the LCM method instead of the cost method. See Exhibit 4.43.1 -2. When the fair market value (“market”) of the merchandise has fallen below cost, the retailer is allowed to recognize that difference even though the loss has not been realized.

With the LCM method, the "market" generally refers to replacement cost for the same goods in the same quantities that the taxpayer would normally acquire. For retailers, the "market" will often be the retail sales price after markdowns and discounts because retail goods tend to have a high obsolescence or change of style factor.

Retailers may determine the cost or the LCM by using the retail method. The retail method uses the relationship of retail price to cost to determine the cost of merchandise in inventory. This method is an averaging method and has historically been more convenient for most types of merchandise, especially as volume increases. If a perpetual inventory is maintained in conjunction with the retail method, a retailer can determine profits, other than shrinkage, without taking frequent physical inventories.

A retailer’s inventory is usually carried on the books at the retail selling price of the various items. The year-end retail price of those goods on hand or market is determined by Treas. Reg. 1.471–8(a) or(d). LCM generates an inventory which is lower than that determined by using the cost method, therefore, it is more likely to be used. Treas. Reg. 1.471–8(d) states that this method is limited to non-LIFO taxpayers who have consistently used the practice of adjusting the retail price in the computation for markups but not markdowns, in conjunction with the retail method. Treas. Reg. 1.471–8(f) states that if this method was not used, a taxpayer may adopt such method provided that permission to do so is obtained from the Commissioner as described in paragraph (c) of Treas. Reg. 1.446–1.

Under the retail method, the LCM value of the ending inventory is computed in the following steps:

Under the retail method, an alternative approach to valuing inventory is the basis of cost per Treas. Reg. 1.471–8(a), rather than the LCM as detailed above. Since this method would generate a higher inventory it is less likely to be used. When it is used, all markup and markdown adjustments are made in determining the retail value.

The retail method requires taxpayers to value their inventory on a department-by-department basis. This is required because the profit margins may be materially different for departments or classes of goods. Treas. Reg. 1.471–8(c) states that "a taxpayer maintaining more than one department in a store or dealing in classes of goods carrying different percentages of gross profit should not use a percentage of profit based on an average for the entire business, but should compute and use in valuing inventory the proper percentages for the respective departments or classes of goods." Therefore, the departments or classes of goods will be equal to the "pools" for LIFO purposes.

It is important that the closing inventory be determined by an actual physical count at least once during a year if not at year-end. The possibility of discrepancies because of total reliance on book inventory calculations is great. If physical inventory is taken at year-end, the cost complement ratio explained above is applied to the physical inventory to arrive at its cost.

It is important to remember that ending inventory is required to include all merchandise owned, both on hand as well as in-transit.

Many taxpayers, especially larger retailers, elect to use the dollar-value LIFO inventory valuation method. A condition placed upon such an election is that it will also be used for the valuation of book inventory. The LIFO method is preferred by many taxpayers because it will in most cases generate the lowest inventory value, by eliminating the increase in inventory due to price changes caused by inflation or other factors. The primary disadvantages of the LIFO method to the taxpayer are the additional computations and the fact that only a cost valuation can result, not the LCM. Taxpayers will use either the "double extension" method or an index method for each pool. Where the taxpayer can demonstrate these methods are impractical the "link-chain" method may be approved. Any method of computing the LIFO value of a dollar-value pool must be used for the year of adoption and for all subsequent years, unless permission to change is received.

Treas. Reg. 1.471–8(a) states that any taxpayer may elect to determine the cost of inventory using the dollar-value LIFO method. The dollar-value method of LIFO inventories determines cost by using base-year data expressed in terms of total dollars, rather than the quantity and price of specific goods as the unit of measurement. Under this method the goods contained in the inventory are grouped into a pool or pools as explained below.

The term base-year cost is the aggregate of the cost of all items in the pool, as of the beginning of the taxable year LIFO was adopted. Subsequent to the initial year each inventory period, or layer, will result in an increment or decrement to the beginning cumulative inventory measured in terms of base year cost. At any year-end the cumulative inventory value of all of the layers will reflect the true growth in inventory, rather than increased dollars relating to the same inventory size caused by price increases.

Treas. Reg. 1 .472–8(c) provides the principal rules for establishing pools. Items of inventory in the hands of wholesalers, retailers, jobbers, and distributors shall be placed into pools by major lines, types or classes of goods. In determining such groupings, customary business classifications of the trade will be an important consideration. The regulations providing for the natural business unit method of pooling may be only employed with the permission of the Commissioner. The appropriateness of the number and composition of the pools used, as well as all computations incidental to such pools, are to be determined by the examination of the taxpayer’s return. The pools selected must be used consistently for all subsequent years unless permission to change is granted by the Commissioner.

The double-extension method is explained at Treas. Reg. 1.472–8(e)(2). The quantity of each item in the pool at the close of the year is extended at both base-year unit cost and current-year unit cost. The two costs are then each totaled. There are specific rules provided which are to be used in determining those costs. Example V of that regulation section serves as an illustration of the computation.

The use of the inventory price index computation (IPIC) is detailed at Treas. Reg. 1.472–8(e)(3). For each pool the index indicates the level of price change that occurs from the beginning of the first fiscal year under the LIFO method. An appropriate index must be used and is subject to challenge by the examiner. As a practical matter most department stores use the price indexes published by the Bureau of Labor Statistics (BLS), which has IRS approval. The BLS index was first published in 1948 with price level data from 1941 and is now published monthly. It contains price change data for 23 individual merchandise groups, as well as combined data for soft goods, durable goods, miscellaneous goods and the store total. It is important that the retailer assign the appropriate departments into each group and consistently maintain such a classification. A review of the many factors entering into the computations made by the taxpayer in developing its own index should be considered during the examination of that taxpayer.

The computations of the retail LIFO inventory method involve the following steps made separately for each pool:

To effectively conduct business an efficient system must be in place to record data pertaining to vendor agreements and products as well as the actual purchase, receipt and payment of merchandise. The retailer must have detailed records of the specific merchandise on hand and where it is located, supplemented with data relating to ordered stock and its scheduled receipt. The retailer needs to know what it is selling, where and at what retail price.

The merchandise systems and records used by retailers will differ in name and format with various levels of detail and sophistication. The retail merchandise records described in the following sections are generic. They represent an automated system of information which would be used by larger retailers.

If the examination of a retailer includes inventory or cost of goods sold the examiner should obtain copies of all appropriate internal procedures of the taxpayer regarding the physical movement of merchandise as well as its associated paperwork and data entry. The examiner should consider discussing these procedures with taxpayer personnel both inside and outside the tax department if clarification is necessary. In many cases an on-site tour of the various facilities where this paperwork and merchandise is physically processed is the most appropriate and effective method of understanding the taxpayer’s merchandise system.

Retail operations may require interaction with thousands of vendors. Due to the volume of purchases as well as the need for quick access to the various data pertaining to these purchases, most retailers will have a sophisticated data system in place.

IRM 4.43.1.2.3 and IRM 4.43.1.2.4 describes the merchandise selection and ordering process. At the time business is first conducted with a manufacturer or product supplier, the buyer will record all data pertaining to the transaction. The record will be expanded as new products are ordered. Listed below are various items of information that may be contained in the vendor data base.

This information could have multiple uses by the agent during the examination of inventory. For example:

The retailer will also have a similar system with detailed information relating to non merchandise vendors. These records, as well as those pertaining to merchandise vendors, may be of value in reviewing a taxpayer’s compliance with the Form 1099 requirements.

Since the time span between the placement of an order and the scheduled delivery date may range from one day to many months it is essential that a thorough record be maintained reflecting the detail of what has been ordered. All merchandise purchase orders, whether an initial order from a new vendor or a routine automated replenishment order, will be entered onto a system of records usually known as the stock ledger system or merchandise record. A segment of that large detailed record is the unfilled order file.

The unfilled order file is one of the records the buyer uses in determining the “open to buy” limit, which is the budgeted dollar amount a buyer is permitted to order for a specific period of time. The merchandise purchases budget is generally based upon sales goals as well as the gross profit goals for each specific department or other classification. Various other employees within the company also monitor and extract information from the file such as distribution center and store delivery dates or payment due dates.

Many retailers will not consider an order filled, for purposes of this system, until the two following events take place:

The year-end merchandise received and not charged to the stock ledger along with unfilled orders could be used by the taxpayer or the examiner to identify additional merchandise owned as of year-end which has not otherwise been included in the inventory shown on the stock ledger. Refer to IRM 4.43.1.4.11.1, for a further discussion of in-transit inventory.

After the purchase order, invoice, and receiving documents have been either automatically or manually matched and reconciled, the vendor’s invoice which has been authorized for payment flows to the retailer’s accounts payable system. The merchandise purchases journal, which contains all entries relating to the purchase of merchandise, is a subsidiary of the accounts payable system.

All documents entering the payables system are coded to reflect the nature of the transaction such as a regular merchandise transaction, a chargeback issued to a vendor, or a payment of an unearned discount. The codes, together with the date and perhaps a batch number, allow source documentation to be subsequently located. They also can be used to summarize transactions into the purchases journal.

The purchases journal may include some or all of the following information:

The purchases journal may also be used as the record reflecting the transfer of merchandise between the warehouse and the store or between two stores. Merchandise physically returned to a vendor is another type of transaction reflected in this record.

Information from the purchases journal can be summarized in very broad or specific categories. The examiner can use this data as part of a review of many items including year-end retail pricing, changes in pooling classifications or vendor allowances. If no year-end data is available from the purchases on order file, the agent might consider extracting merchandise in transit amounts from the purchases journal using posting dates after year-end for invoices dated before year-end, as explained more thoroughly in IRM 4.43.1.5.8.

The retail price of a product is initially established at or before the time of purchase, usually as part of the overall purchase negotiation process. The buyer may enter the original retail price of the product into the retailer’s retained copy of the purchase order. The retail price then would become part of the internal data base for that vendor. Subsequent to the initial purchase, the data base will be used to assign and change the retail price of inventory automatically.

The original retail price established for merchandise purchased is subject to numerous changes. Only certain employees within the organization, such as buyers, have authority to change the price of merchandise. Iin most cases the originator of the change must have the approval of another party to do so. These authorizations and limitations are spelled out in the retailer’s internal procedures manual which will also specify entry codes and descriptions used for price changes.

The taxpayer, having previously established the number and department content of inventory pools, must accumulate year-end summary of data for each pool. Totals for each department in the various pools may be extracted from the stock ledger or merchandise report. The taxpayer will need some or all of the following information:

All merchandise received, whether or not it is yet recorded in the stock ledger, must be included in ending inventory computations. The taxpayer must also accumulate information pertaining to the retail and cost of in-transit merchandise, stock which the taxpayer owns but which has not yet been received. The likely source of this information as of year-end would be an extract from the purchases on order file. An alternative method used by some retailers for convenience to determine the amount of in-transit inventory at year-end is to extract post year-end entries made to the purchases journal. Refer to IRM 4.43.1.5.10.1, for a complete discussion of in-transit inventory.

These totals by department are then summarized by pool, adding together all of the departments which belong in each pool.

The taxpayer will also have a summary report showing the cumulative total markdowns for each type of markdown. This report would be an extract from the stock ledger or the price change records. If LIFO is used in conjunction with the retail method, as it is by most larger retailers, the taxpayer should have detail showing the portion of the total permanent markdowns applicable to this year’s purchases. Similar to the above data, these totals must be accumulated by department and by pool.

The examiner should review these figures, reconciling ending book inventory and cumulative purchases at cost to the appropriate general ledger accounts. In addition, the propriety and consistency of the departments included in each pool should be reviewed. The examiner should also determine if the amount of in-transit inventory reflected is correct.

The cost complement is the percentage of retail price which represents cost. The summary information compiled by the taxpayer as explained in IRM 4.43.1.3.3.2 is used to determine the cost complement. A new cost complement is computed each year for each pool. There are three different cost complement formulas to use with the retail method, one for each inventory valuation method elected. The differences in the computations are described below.

The differences between the computations is demonstrated in Exhibit 4.43.1-3 by using the same facts applied to each of the three sets of rules. Note the differences in the methods and how the incorporation of permanent markdowns increases the cost complement. Although the LIFO method cost complement is the highest, the percentage will be applied against reduced retail dollars during inflationary years.

The examiner should secure and review these computations for each pool, taking note of any unusual or unexplained differences in the percentages between years. Determine if the appropriate markdowns were used in the computation. Determine if the cost complement of the in-transit inventory alone, when compared with on hand inventory, is reasonable. The more the retailer uses permanent markdowns the greater the difference in the two cost complements, since the in-transit merchandise should have few, if any, permanent markdowns taken prior to its receipt.

The LIFO method is designed to eliminate the increase in inventory caused by inflation. Year-end inventory at retail is converted to a base-year retail dollar amount using a factor. The resulting base-year amount is then compared with the beginning inventory amount which was similarly converted. The difference between the beginning and ending inventory amounts, now shown in terms of the base-year constant dollars, represents the true growth (or reduction) in inventory.

The conversion factor used is in the form of an annual inflation index. The annual index can be obtained from either of the following:

Most non-grocery large retail operations are eligible to elect to use the price change index, known as the Consumer Price Index (CPI), published by the U.S. Bureau of Labor Statistics (BLS). The taxpayer must compute inventory values by class groupings that correspond to BLS index categories. If appropriate, a retailer may elect to use the Producer Price Index (PPI), also published by the BLS. Retailers using the retail inventory method in connection with the PPI must increase the index to reflect the profit factor. Retailers on a cost method using the CPI must eliminate the profit element in the index, using its own profit experience in making this adjustment.

All taxpayers, except those retailers eligible to use BLS indexes, may elect the IPIC method described in Treas. Reg. 1.472–8(e)(3). Taxpayers electing this method must apply it to all LIFO inventories. The IPIC method limits taxpayers to 80 percent of the percent change in the BLS indexes, except for a small business taxpayer, as defined by IRC section 474, which can use 100 percent of the stated change.

Some taxpayers, primarily grocery operations, develop their own index by selecting a sample of products in each pool. By comparing the current year’s price to the prior year’s price for each product sampled and accumulating the results, the average price change for the pool can be determined.

Many taxpayers in the grocery business have changed to the IPIC method to value their LIFO inventory. Although the intent of the IPIC method was to simplify the LIFO computation, many taxpayers have taken shortcuts that may distort the LIFO inventory. Please refer to IRM 4.43.1.3.3.5, use of dual indexes, and IRM 4.43.1.4.11.4 for additional details.

Regardless of the method used, the examiner should request the detail of the computations supporting the development of the index and become familiar with the rules within that method.

For taxpayers using the retail method, the examiner should ascertain whether the taxpayer has developed a different pricing policy which may impact on the use of indexes. Since the indexes are applied to the year-end retail price of the product, any change in the pricing of the goods in the pool during the year may materially change the gross profit percentage. Those changes are not accounted for in the price change index developed by the BLS. The changes should be analyzed to determine if they materially impact on the inventory computations.

Prior texts described the steps necessary to compute the current year LIFO inventory and the mechanics of the lapse schedules. The taxpayer will conclude the computations by preparing a final summary schedule showing the current year amounts, with one line or column for each pool. The final LIFO inventory computations for each pool will be recapped in this section for ease of review.

A sample computation of a retail LIFO inventory summary as explained above is provided as Exhibit 4.43.1- 4. The example shows the current year inventory position of the two pools.

The examiner should become familiar with the overall computation of the retailer’s inventory. Adjustments to any facet of the calculation, including ending inventory at retail, price indexes, or cost complement percentages will impact the LIFO computation.

If changes are made to the taxpayer’s LIFO inventory computations, the examiner should consider requesting the taxpayer’s computer file containing the tax return calculations. This file could then be modified to incorporate additional columns reflecting the changes as well as the corrected inventory. This technique will eliminate a significant amount of raw data input, it will include necessary formulas and it will be user friendly to the taxpayer due to its familiarity.

The computations described in the prior texts are incorporated into the calculation of the LIFO inventory. The steps involved in the LIFO calculation by a taxpayer employing the retail method are outlined below. Computations are made for each LIFO pool which the retailer uses. As part of those computation the taxpayer must refer to the prior year computations, which are summarized on a permanent LIFO inventory record, known as a layer or lapse schedule. The lapse schedule should provide the complete historical detail of the taxpayer’s LIFO computations.

There is generally one schedule for each LIFO group or pool. The schedule commences at the time the taxpayer elected to use the LIFO method. Each year or period thereafter should have its own entry line, reflecting the computations for that layer. If there is an increment, the details of the LIFO inventory increase will be summarized. If there is a decrement, the details of the LIFO inventory decrease, including the impact on the prior layers, will be summarized.

An example of a LIFO lapse schedule is shown in Exhibit 4.43.1-5. Pool 1 contains increments in each layer of inventory. Pool 2 shows a current year decrement and the use of the prior year’s index and cost complement to measure the decrease in terms of LIFO inventory.

The examiner should request and review the historical LIFO lapse schedules. They will provide insight regarding whether the taxpayer is complying with the LIFO computational requirements. They also may provide indications of changes made to pools, business emphasis changes, the pattern of the cost complement factors, and the propriety of the price index figures used. If adjustments are made to the taxpayer’s LIFO calculations by the examiner for any year, this summary record also must be modified by the taxpayer to incorporate those changes.

Retailers may take a physical inventory of goods at various times during the year.

The frequency of taking a physical inventory of goods also varies among retailers. Chain grocery stores may take a physical count as often as every four weeks. Most non-grocery retailers will take a physical inventory of goods once or twice each year.

The examiner should request the taxpayer to provide a schedule of dates on which the merchandise at each location was counted during the year.

The examiner should also request the physical inventory procedures and instructions pertaining to the years under audit. There may be separate instructions for store and distribution centers. These procedures should be reviewed for indications of an incomplete or inaccurate inventory.

Stock shortage, also known as inventory shrinkage, is the difference between book inventory and the actual physical inventory. There are numerous causes of shrinkage, including theft, breakage, spoilage, and a broad range of bookkeeping errors. Shrinkage may also result from the failure to count all merchandise that is on-hand when the physical inventory is taken.

Nearly all retailers experience some amount of inventory shortage during the course of the year. There are various methods employed by retailers to account for shortage.

If an accurate physical inventory was taken at year-end, and the inventory balance was corrected by the taxpayer to reflect those results, the fact that the taxpayer estimated shrinkage during the year would not be relevant.

If the taxpayer did not take a year-end inventory, the examiner should ask the taxpayer how he accounted for inventory shrinkage that occurred during the period between the most recent physical inventory of goods and the year-end. If the book inventory was reduced by a shrinkage estimate, the examiner should request from the taxpayer all detailed computations relating to the shrinkage estimate. The taxpayer must provide a detailed description of all aspects of the new method of estimating inventory shrinkage.

The actual physical count of goods may be made by employees, by inventory consulting firms or by other organizations. Generally, the taxpayer will also have selected management, inventory personnel and outside auditors present. With technological advances such as hand held computers and scanners, the process of taking inventory should be less time consuming and more accurate.

The procedures used by retailers to conduct the physical inventory were previously outlined at IRM 4.43.1.3.3.6. The taxpayer should have available the documents completed by the counters and the magnetic tape of the physical inventory.

The taxpayer’s written inventory procedures will also include a significant amount of detail regarding how the taxpayer accounts for the various transactions taking place on the last few days before the physical. For retailers using a perpetual inventory system the taxpayer may start with book inventory, which includes processed documents as of the inventory date. That book inventory must be modified to a corrected book inventory, accounting for all transactions which would have physically added or removed merchandise from the recorded book inventory.

The examiner should request these reconciliation forms and their related instructions and review the propriety of the reconciling items.

The examiner should question employees responsible for inventory reconciliation if the tax department personnel cannot adequately explain aspects of the reconciliation.

The information included with the return itself may be limited to the amount capitalized, the percentage increase in inventory due to IRC section 263A and the checklist previously discussed at IRM 4.43.1.3.4.

In the initial IDR, request the following:

The following steps will assist the examiner in identifying costs which should be capitalized.

If certain cost centers, which should be under the UNICAP rules, were either not included by the taxpayer or appear to be under-allocated, examiners should consider interviewing some of the employees in these cost centers to verify the taxpayer's allocation.

As part of opening a new location or updating an existing one, the taxpayer will prepare or contract for bid packages and drawings which are used to establish costs and identify contractors throughout the entire construction project. During construction the various contractors, including structural, concrete, electrical, mechanical and finish, will request periodic reimbursement based on the amount of work completed to date. These requests are often reviewed and approved by a third party contract administrator. Typically, a percentage (10 percent) is withheld by the taxpayer until final completion. This amount, referred to as retainage, provides assurance that everything is completed satisfactorily prior to final payment.

The taxpayer usually will maintain a file for each new store or remodeling project. The file contains all data pertinent to the project, including contractor payments and invoices and payments for store fixtures. Land may not be part of the file because the site may have been purchased much earlier. During construction or after completion of the project the payments and invoices from the file are used to establish capital assets on the fixed asset record system.