A study of the link-chain LIFO controversy

Abstract

The accounting literature contains no evidence on the reliability of the link-chain variant of dollar-value LIFO as a method of inventory accounting as compared to the double-extension variant. The research produced the first evidence on the topic. Process analyses of the two methods found both to be flawed, with the link-chain method seriously flawed. The link-chain method inappropriately incorporates the price-levels of periods when there is no annual layer to be restated. The resulting, and all subsequent, inventory valuations are misstated. The link-chain and double-extension methods can both produce misstated valuations in periods with layer erosion. The study identifies procedures to correct these errors. Two quantitative experiments were conducted to evaluate the relationship of the inventory valuations produced by the two methods. The first experiment used a small amount real data; the second experiment used a large amount of synthesized data. The experimental results indicated the relationship of the valuations to be circumstantial. Based on the process analyses and the quantitative experiments, the link-chain LIFO method was determined to be an unreliable method of inventory accounting. The quantitative experiments were also used to investigate related issues. The first experiment concluded that a dollar-value LIFO method based on Fisher’s "ideal" index methodology was practicable. The second experiment concluded that adopting the method used by the Bureau of Labor Statistics to assign base-date costs to new or changed items that enter the CPI market basket of goods and services to the double-extension LIFO method was practicable and would not diminish tax revenues. The study recommended that consideration be given to replacing the current double-extension and link-chain methods with a double-extension LIFO with the BLS method. The second experiment also concluded that the IRS’s inventory "turnover" test is probably based on the IRS’s perception of what constitutes taxpayer practicality. The definition of practicality, however, is questioned and alternative definitions are suggested. The study indicated that further research on the relationship of inventory valuations to the income taxation process is needed.