Rev. Proc. 77-7

Section 1. Purpose.

The purpose of this Revenue Procedure is to set forth the application of section 472(c) and (e)(2) of the Internal Revenue Code of 1954 to taxpayers who employ the last-in, first-out (LIFO) inventory method and are required by the Securities and Exchange Commission (SEC) to make certain replacement cost disclosures in their financial statements.

Sec. 2. Scope.

This Revenue Procedure is limited to those taxpayers who employ the LIFO inventory method and are subject to the replacement cost disclosure requirements, adopted by the SEC as Rule 3-17 of Regulation S-X (17 CFR 210. 3-17).

Sec. 3. Background.

Section 472(a) of the Code permits a taxpayer to elect the LIFO inventory method. Section 472(b) states that under the LIFO method a taxpayer shall (1) Treat the goods remaining on hand at the close of the taxable year as being: First, those included in the opening inventory of the taxable year to the extent thereof, and second, those acquired during the taxable year; (2) Inventory the goods at cost; and (3) Treat the goods included in the opening inventory of the taxable year in which the LIFO 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 states that if the taxpayer employs the LIFO method as described in section 472(b), the taxpayer shall establish to the satisfaction of the Secretary of the Treasury or the Secretary's 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 to shareholders, partners, proprietors, or beneficiaries, or for credit purposes.

Section 472(e)(2) of the Code imposes a requirement similar to that contained in section 472(c) for taxable years subsequent to the year of the LIFO election and states that the Secretary or the Secretary's delegate may require a taxpayer to discontinue the use of the LIFO method if the taxpayer has violated the requirement.

Rule 3-17 of Regulation S-X requires that certain replacement cost information be disclosed by SEC registrants, except those whose inventories and gross property, plant and equipment (before depreciation, depletion and amortization) as shown in the consolidated balance sheet at the beginning of the fiscal year is less than $100 million or those whose inventories, gross property, plant and equipment is less than 10 percent of the consolidated balance sheet assets. Required disclosures include the following:

(a) the current replacement cost of inventories at each fiscal year end for which a balance sheet is required,

(b) for the two most recent fiscal years, the approximate amount that cost of sales would have been if it had been calculated by estimating the current replacement cost of goods and services sold at the time when the sales were made,

(c) a description of the methods used and the considerations given in determining (a) and (b), and

(d) any additional information that management is aware of and is necessary to prevent the information presented from being misleading.

Sec. 4. Application.

.01 The Internal Revenue Service has received numerous inquiries from taxpayers who employ the LIFO inventory method and are subject to the SEC replacement cost disclosure requirements. The particular concern is whether the Service will disallow a taxpayer's LIFO election or require a change from the taxpayer's LIFO method due to a violation of section 472(c) or (e)(2) of the Code, if the taxpayer discloses such replacement cost information in its financial statements.

.02 The conformity requirements of section 472(c) and (e)(2) of the Code relate to the computation of income on a method other than LIFO. A computation of cost of goods sold is an integral part of the computation of income. Therefore, the computation of cost of goods sold when the LIFO method is employed must adhere to the LIFO procedures.

.03 A statement, such as a footnote in an annual financial statement, that discloses the effect on cost of goods sold (and therefore income) by using replacement cost, which is a procedure other than LIFO, is a violation of section 472(c) and (e)(2) of the Code (see section 3 above). However, the Service will not disallow a taxpayer's LIFO election or require a change from the taxpayer's LIFO method because of such disclosure during the period permitted by section 5 below, when the disclosure is made pursuant to the SEC requirements.

.04 With respect to the disclosure regarding the current replacement cost of inventories (see section 3 above), the Internal Revenue Service has previously announced in Rev. Rul. 75-50, 1975-1 C.B. 152, which amplified Rev. Rul. 73-66, 1973-1 C.B. 218, that it will not terminate a taxpayer's LIFO election because of such a balance sheet disclosure. For purposes of satisfying the SEC replacement cost disclosure requirements, the permissible scope of the Rev. Rul. 75-50 disclosure is modified to include that allowed by section 4.05 below.

.05 The disclosures permitted must be in such form as is acceptable to the SEC. For this purpose, SEC Staff Accounting Bulletin No. 12 and Staff Accounting Bulletin No. 13 (SAB 12 and SAB 13) provide examples of footnote disclosures that are acceptable to the SEC. Although the Service will not require literal adherence to the language in the examples in SAB 12 and SAB 13, the Service will require that the substance of the disclosures as they relate to cost of goods sold closely adhere to those examples. A disclosure of the effect on cost of goods sold if the first-in, first-out (FIFO) inventory method had been used is not permitted.

.06 Taxpayers subject to SEC replacement cost requirements will be required to continue the use of historical cost for purposes of the primary presentation of their financial statements.

.07 During 1977 and 1978, the SEC will conduct an in depth review of the replacement cost information received pursuant to Rule 3-17. This review will include a consideration of the utility of the replacement cost information for investors and management.

Sec. 5. Effective Date.

This Revenue Procedure is effective for financial statements for taxable years ending on or after December 25, 1976, but is not effective for financial statements for taxable years ending on or after December 25, 1977.

¹ Also released as IR-1745, dated February 1, 1977.