Rev. Rul. 77-152

Advice has been requested whether a taxpayer using the last-in, first-out ("LIFO") method of inventory valuation as described in section 472 of the Internal Revenue Code of 1954 may compute, under the circumstances described below, an inventory value for its Federal income tax return that is different from such value used in a preliminary financial statement.

Corporation X has previously elected the LIFO inventory method. X is licensed by corporation Y to manufacture and sell the latter's product. The licensing agreement was entered into on January 1, 1970, and runs for a period of 20 years. The agreement requires that X pay Y based on a percentage of sales. The agreement also requires X to provide Y with an annual financial statement, including information on bank balances, accounts receivable, inventories, other assets, and liabilities. The financial statement must be provided no later than the tenth day of the month following the end of the year to which the statement relates.

X has consistently furnished Y a preliminary report for the year involved by using estimates of the various account balances. X used the LIFO inventory method in preparing the preliminary report that is submitted to Y for the year ended December 31, 1974.

In estimating the LIFO inventory in that preliminary report, X estimated the number of units on hand at the end of the year, which estimate resulted in an additional number of units above the number on hand at the beginning of the year. The value of this new layer was based upon available cost estimates. These procedures used by X in preparing the estimates were reviewed by its independent accounting firm. The procedures were designed to conform to the LIFO method of inventory valuation.

Prior to the preparation of X's final financial statement of 1974, and before the due date (including extensions) for filing X's Federal income tax return, the detailed computations of the LIFO values were made. These computations contained more accurate LIFO information than that stated in the preliminary report. The corrected values supplied to Y were included in X's annual financial statement to shareholders for 1974 and, later, in its Federal income tax return for 1974.

Section 472 of the Code provides certain criteria for the adoption and use of the LIFO inventory method. Section 1.472-2(e) of the Income Tax Regulations provides, in part, as one of the requirements incident to the adoption and the use of the LIFO inventory method, that the taxpayer shall establish to the satisfaction of the Commissioner of Internal Revenue that, in ascertaining income, profit, or loss for the taxable year for which the inventory method is first used or for any subsequent taxable year, for credit purposes or for the purposes of reports to shareholders, partners, or other proprietors, or to beneficiaries, the taxpayer has not used any inventory method other than LIFO.

Y, by reason of the license agreement, is considered to be a creditor of X for purposes of section 472 of the Code. Although the information provided to Y is a preliminary report, the report covers the entire year and, therefore, is subject to the conformity requirement.

In Rev. Rul. 76-531, 1976-2 C.B. 140, it was determined that the financial conformity requirement in section 472(c) and (e)(2) of the Code is tied solely to the sequential layering provisions of section 472(b)(1) and (3) and does not require that the cost used for Federal income tax purposes also be used for financial statement purposes. The method used for financial purposes must, however, conform with the sequential layering provisions inherent in the LIFO method.

In computing the preliminary LIFO inventory in the instant case, X maintained the sequential layering concept since the only estimates pertain to the additional layer added during the year covered by the preliminary report. While the estimated cost of this particular layer did not agree with the actual cost later determined and used for tax purposes, there is no requirement that they do agree. See, for example, Rev. Rul. 76-531. In the process of estimating the current year's layer, the taxpayer nevertheless respected the individual cost identities of the earlier layers. Furthermore, the preliminary financial statement does not include footnotes or other commentary containing any unauthorized express or implied comparison of what earnings or earnings per share would be under a method other than LIFO. Compare Rev. Rul. 74-586, 1974-2 C.B. 156 and Rev. Proc. 75-10, 1975-1 C.B. 651.

Accordingly, in the instant case, there is no violation of the conformity requirement of section 472 of the Code merely because the preliminary financial statement was prepared using a LIFO estimate.