Inventory Conformity Rule

The inventory conformity rule, usually called the LIFO conformity rule, is a provision of US federal tax law that requires a taxpayer that uses the last in, first out (LIFO) inventory method to calculate taxable income to also use LIFO when reporting income, profit or loss for the year in financial statements issued to shareholders, partners, creditors and other owners. In short, a company cannot use LIFO to lower its taxes while showing higher profits to investors using another method such as first in, first out. In inventory contexts it is often called simply the conformity rule.

The rule is set out in section 472(c) of the Internal Revenue Code, with further requirements in section 472(e) and the related Treasury regulations. It is unusual, because US tax law generally does not dictate how companies prepare their published accounts; in most areas, tax and financial reporting follow separate rules.

LIFO assumes that the most recently acquired inventory is sold first. When prices are rising, this matches higher recent costs against revenue, which raises cost of goods sold, lowers taxable income and defers income tax. Congress allowed LIFO for tax purposes in the Revenue Acts of 1938 and 1939, in part because businesses argued that it gave a truer measure of income during periods of inflation. The conformity requirement was the price of that permission: if a company believes LIFO best reflects its income, it should say so to its investors as well as to the Internal Revenue Service.

The core requirement applies to the primary presentation of income for the taxable year in the income statement and similar reports to owners and creditors. Over the years, the Treasury regulations have relaxed the rule in several ways. A LIFO company may generally:

• Disclose, in notes or supplementary information, what its income or inventory would have been under a non-LIFO method, as long as that information is clearly presented as supplemental.
• Report its inventory on the balance sheet at a non-LIFO value, such as FIFO, with the LIFO adjustment shown separately.
• Use non-LIFO methods in internal management reports that are not issued to owners or creditors.
• Present interim reports and reports covering periods other than the full tax year using non-LIFO methods, subject to certain conditions.

What it cannot do is present non-LIFO income as the main measure of profit for the year in its financial statements. Breaking the rule can lead the IRS to terminate the company's LIFO election, which would force it to recapture the accumulated tax benefit.

Because of the rule, US companies using LIFO typically disclose a LIFO reserve, the difference between inventory valued at FIFO (or current cost) and inventory valued at LIFO. Suppose a hardware distributor reports LIFO inventory of $60 million and discloses a LIFO reserve of $18 million. Its inventory under FIFO would be $78 million, and its cumulative pre-tax income since adopting LIFO would have been $18 million higher. At a 21 percent federal tax rate, the company has deferred roughly $3.8 million of federal tax. If the LIFO reserve grew by $2 million during the year, FIFO-based pre-tax income would have been $2 million higher than reported. Analysts use these disclosures to compare LIFO companies with peers using other methods.

The conformity rule means that companies choosing LIFO for its tax benefits must accept lower reported profits and lower inventory values in their financial statements during periods of rising prices. It is also one of the main obstacles to US adoption of International Financial Reporting Standards, which prohibit LIFO: a US company switching to IFRS for its published accounts would lose the right to use LIFO for tax unless Congress changed the law. Repeal of LIFO for tax purposes has been proposed several times as a way to raise revenue, but it has not been enacted. Companies using LIFO tend to be in industries with large, slow-moving and inflation-sensitive inventories, such as oil refining, chemicals, metals, auto dealerships and wholesale distribution. The choice of cost flow assumption therefore has consequences far beyond the inventory note, especially when inflation is high, and it is explained in the company's accounting policies.