Rev. Rul. 74-586

The Internal Revenue Service has been asked to set forth its position on the types of financial statement disclosures that may warrant a termination of a Last-in, First-out (LIFO) inventory election under sections 472(c) and (e) of the Internal Revenue Code of 1954.

Section 472(a) of the Code provides, in part, that a taxpayer may use the method provided in section 472(b) in inventorying goods specified in an application to use such method filed at such time and in such manner as the Secretary or his delegate may prescribe.

Section 472(b) of the Code provides, in part, that in inventorying goods specified in the application in section 472(a), the taxpayer shall:

(1) Treat those remaining on hand at the close of the taxable year as being: First, those included in the opening inventory of the taxable year (in order of acquisition) to the extent thereof; and second, those acquired in the taxable year;

(2) Inventory them at cost; and

(3) Treat those included in the opening inventory of the taxable year in which such method is first used as having been acquired at the same time and determine their cost by the average cost method.

Section 472(c) of the Code provides that subsection (a) shall apply only if the taxpayer establishes to the satisfaction of the Secretary or his delegate that the taxpayer has used no procedure other than that specified in paragraphs (1) and (3) of subsection (b) in inventorying such goods to ascertain the income, profit, or loss of the first taxable year for which the method described in subsection (b) is to be used, for the purpose of a report or statement covering such taxable year--

(1) to shareholders, partners, or other proprietors, or to beneficiaries, or

(2) for credit purposes.

Section 472(e) of the Code provides, in part, that if a taxpayer having complied with section 472(a) uses the method described in section 472(b) for any taxable year, then such method shall be used in all subsequent years unless the Secretary or his delegate determines that the taxpayer has used for any such subsequent taxable year some procedure other than that specified in paragraph (1) of subsection (b) in inventorying the goods specified in the application to ascertain the income, profit, or loss of such subsequent taxable year for the purpose of a report or statement covering such taxable year (A) to shareholders, partners, or other proprietors, or beneficiaries, or (B) for credit purposes; and requires a change to a method different from that prescribed in subsection (b) beginning with such subsequent taxable year or any taxable year thereafter.

The above provisions of section 472 of the Code and the Income Tax Regulations thereunder require a conformity of the taxpayer's financial statements with the LIFO inventory method used for Federal income tax purposes, and thus permit no other inventory method to be used in such statements.

The committee reports of the Revenue Bill of 1939, S. Rep. No. 648, 76th Cong., 1st Sess., (1939), 1939-2 C.B. 524, 528, stated that a taxpayer who elects to use the optional method of inventory, provided by the bill, * * * must specify the goods with respect to which the method is to be used. The taxpayer must show that he, for the period the method is to be used for tax purposes, has used no other method for certain business purposes such as income statements, applications for bank loans, and reports to shareholders. * * *

* * * * *

To remain qualified to use the method, the taxpayer must continue to use it for tax and the business purposes indicated above. The Commissioner may, however, permit him to change. The Commissioner may require him to change to a different method if the taxpayer changes; but even if the taxpayer does change to a different method for other purposes, the Commissioner may require him to continue to use the method for tax purposes. * * *

The legislative history indicates that the purpose of this conformity requirement was to give assurance that with respect to a particular taxpayer the LIFO method clearly reflects income.

In Rev. Rul. 73-66, 1973-1 C.B. 218, the Service held that the following footnote appearing in the balance sheet section of a taxpayer's financial statements would not violate the LIFO conformity requirements:

If the first-in, first-out (FIFO) method of inventory accounting had been used by the company, inventories would have been $ and $ higher than reported at December 31, 19, and December 31, 19, respectively.

Rev. Rul. 73-66 stated as a fact that in all other respects in the annual reports and for all other financial statement purposes, including income statements, balance sheets, and reports of earnings per share, the taxpayer will use only the LIFO inventory method and that no further explanatory statements with respect to inventories will be made on the taxpayer's statements and reports.

In Rev. Proc. 72-29, 1972-1 C.B. 757, the Service indicated it would not terminate a LIFO election if there were variations between the LIFO method for financial and tax purposes that were caused by the application of financial accounting principles with respect to certain types of business combinations.

Rev. Proc. 73-37, 1973-2 C.B. 501, provided similarly when a taxpayer was required to provide certain supplemental financial statement information in the taxable year in which the LIFO method was elected.

Rev. Proc. 74-18, 1974-1 C.B. 439, provided that the Service would not terminate a taxpayer's LIFO election if certain financial statement information was required because of unexpected increases in Bureau of Labor Statistics price index figures. However, application of this Revenue Procedure was limited to the fiscal year ended on or about January 31, 1974.

Each of the above Revenue Procedures related to specific transactions or unusual circumstances that were deemed to warrant an exception. No inference should be drawn from these Revenue Procedures as to factual situations that might be deemed to justify further exceptions.

It is the position of the Service that footnotes or commentary in the annual financial statements, other than those disclosures specifically permitted by the Revenue Procedures cited above, which serve to indicate the effect on net earnings or earnings per share of an inventory method other than the LIFO method, such as the FIFO method, constitute a violation of the conformity requirements of section 472(c) and (e) of the Code.

Since it is a violation of the conformity requirement for a LIFO-method taxpayer to use a method other than the LIFO method in the financial statements, it is equally a violation to use the LIFO method in the body of the financial statements and then to indicate either in footnotes or other commentary to the annual financial statements what the earnings or earnings per share would have been under a method other than the LIFO method. Such footnotes or commentary are a part of the financial statements and income ascertainment on the basis of a method other than LIFO accomplished in this manner is essentially similar to such computation appearing in the body of the statements. In either case, the purpose of the conformity requirement has been violated, in the sense that the LIFO method has been used for Federal income tax purposes, and a method other than the LIFO method has been used or compared with in the financial statements to show a different amount of earnings to shareholders or creditors.

Accordingly, it is held that it is a violation of the LIFO conformity provisions of section 472 of the Code for a taxpayer in its annual reports, annual financial statements, annual news releases, etc. to provide a footnote or other commentary that compares or states what the earnings or earnings per share would have been under any other inventory method than LIFO. Such a violation may result in a termination of the LIFO method under section 472(c) or (e).

Information specifically permitted under Rev. Proc. 72-29, 73-37, and Rev. Rul. 73-66, are exceptions to the above holding (Rev. Proc. 74-18 being specifically applicable only to the fiscal year of certain taxpayers ending on or about January 31, 1974). Taxpayers desiring further guidance may submit requests for rulings in accordance with the provisions of Rev. Proc. 72-3, 1972-1 C.B. 698.

Under the authority of section 7805(b) of the Code, this Revenue Ruling will be applicable only to annual financial statements, annual reports, annual news releases, etc., issued after January 8, 1975. Issuances of such statements, etc. prior to that date that contain footnotes or commentary which serve to indicate the effect on net earnings or earnings per share of an inventory method other than the LIFO method will not result in a termination of a taxpayer's LIFO election provided that the LIFO method was used in the preparation of the annual financial statements.

See Rev. Proc. 74-52 which revokes Rev. Proc. 74-18.