340aclass 25
April 22, 2002
Next time:
Retail Method
Exam 3 is next Monday!
Extra credit questions for Exam 3 are due by Wednesday at 5
Old Exam 3 is on the web now - use it to test yourself (after you study)
Wednesday's notes will include a study guide as well
Today:
Making LIFO adjustments
Chapter 10
lower of cost or market
Pooled LIFO
DV LIFO - intro
Lower of cost or market
Assume we determined that our inventory is worth $52 valued at LIFO for 7 bags.
What if the market value of M&M’s had fallen to $6 a bag?
Ex. ATARI and beta tapes: a whole warehouse section full (I talked about this in class earlier - about my audit client that had a whole bunch of "worthless" inventory)
CONSERVATISM kicks in > Lower of cost or market rule (LCM)
Because of conservatism, we don’t want inventory valued at an unrealizable amount
Ex. LIFO cost $52 , Mkt value $42 (7 bags @ $6 per bag) ; Conservatism tells us that we should show a value of $42 on our balance sheet for this inventory.
What if market value jumped to $10 bag?
NO ENTRY: again because of CONSERVATISM
BUT!!!!!
Where does market value come from?
We come up with a designated market value idea based upon three values:
Replacement cost (what we would have to pay to replace our inventory)
Ceiling (NRV or (Sales price less costs to complete or dispose of))
Floor (NRV less profit margin)
Designated market value is the MIDDLE of these 3 values
In-class Example of LCM rules:
Sales price $10 per bag
Disposal cost $2 per bag (cost to actually move M&M’s)
Profit margin (20% of Sales price)
Ceiling = $10-$2 = $8 = NRV (what we expect to get for the M&M’s)
Floor = $8 - $2 = $6 = NRV-profit margin (what if I made no profit)
Cost to replace: $5 (what if I had to buy new M&M’s) – from the last purchase price
Compare: $8 $6 $5 .> choose middle value as DESIGNATED MARKET VALUE
Compare Cost under LIFO ($52 in total) to Market value (7 bags at $6 or $42) > use $6 to value inventory for financial statements
Accounting for the LCM adjustment: There are 2 acceptable ways to handle the LCM writedown. They both lead to identical income statement and balance sheet totals.
1. Direct inventory reduction method: Here you make the following adjustment for the writedown amount:
(E)Cost of goods sold$10
(A)Inventory$10
To report the reduction to market value.
2. Inventory allowance method: Here you don't mess with your inventory or cost of goods sold accounts directly:
(E)Holding loss on inventory$10
(A)Allowance to reduce inventory to LCM$10
To report the reduction to market value.
One other odd LIFO thing:
LIFO Adoption rule: What does a change in method usually require? Think about the income statement line item, "Cumulative change in accounting principle" --- usually a catch-up entry is required to adjust the books to reflect the new method "as if" it had been used all along. What would this mean if you switched from FIFO to LIFO? (You would be switching from a method that keeps your newest costs on the balance sheet (FIFO) to a method that results in your oldest costs on the balance sheet (LIFO). Where would the old cost information come from?) It would be a MAJOR HEADACHE!! Fortunately, the FASB made an exception to the Cumulative Change rule for LIFO Adoption.
>When you adopt LIFO, the ending inventory for the year prior to adoption, valued at the old method, is the beginning inventory for the adoption year. (So you just would use the ending FIFO balance from the prior year as your beginning LIFO inventory in the year of the change to LIFO).
NOW ON TO THE SHORTCUTS
Pooled LIFO: this method groups different products or items into one inventory category, or pool. The advantage is mainly one of record-keeping simplification. Another advantage is that LIFO liquidation is less likely when inventory pools are used. Why? It has to do with diversification - if you have a large number of different products in one pool, the chances of all of the products changing enough in price or in use to trigger a liquidation of the whole pool is smaller.
Dollar value LIFO:
why? to ease some of the headaches of LIFO (which, remember don't outweigh the headaches caused by paying higher taxes under other inventory methods)
Focus is even further removed from the physical unit flow. The inventory balance is determined for POOLS of INVENTORY DOLLARS:
Inclass 24 example (simple in-class 3 years)
Gert's keeps her inventory on a FIFO basis for internal recordkeeping. In 1998, she adopted LIFO for financial reporting purposes. Gert's has the following information regarding inventory balances for the last 3 years:
Ending Inventory(FIFO)Index
Balance, 12/31/97 (LIFO adoption year)$9,0001.00
Balance, 12/31/98 (at end of yr dollars)$10,5001.07
Balance, 12/31/99 (at end of yr dollars)$11,2501.12
Balance, 12/31/00 (at end of yr dollars)$12,0001.20
>What's the INDEX? This index uses 1997 as the BASE YEAR. The index means that prices at the end of 1998 are 1.07 times what they were at the end of 1997. At the end of 1999, prices are 1.12 times what they were at the end of 1997.
Purchases: 1998 $25,000
Purchases: 1999 $20,000
Purchases: 2000 $20,000
Required: Compute the DV LIFO for 12/31/98, 99, and 00:
Outline for 1998 (Do together in class):
5 steps:
1) Convert ending inventory to base year dollars: (Remember this is ending inventory in 1998 $$- FIFO)
$10,500 * (1.00/1.07) = $9,813
(Note: This amount tells you how much this same level of inventory would have cost in 1997)
2) Determine the change in base year dollars:
(1) -beginning inventory in BASE year dollars (*** this is tricky in Year 2! - Remember to use Year 1 line 1 as the beginning inventory in BASE year dollars)
$9,813-$9,000 = $813
(Note: This tells you how much the inventory has grown, without the effects of price increases)
>If the change is negative, you have to eat into the beginning inventory in BASE year $$, starting with the latest layer (see Ruby example on the next page) >
3) Convert an INCREASE to CURRENT year dollars to get the LIFO layer:
(2) * current year index
$813*(1.07/1.00) = $870
(Note: This is the inventory change (increase only) in current $$)
4) Add up LIFO layers to get ending DV LIFO:
1997: $9,000 DVLIFO
1998:$ 870 DVLIFO
total$9,870 DV LIFO
(Note: 1997 layer is in 1997 dollars, 1998 layer is in 1998 dollars)
5) Determine COGS (Use the INVENTORY IDENTITY):
Purchases = $25,000
COGS = Beg. Inventory DVLIFO + Purchases - End. Inventory DVLIFO
? = 9,000 +25,000 -9,870
=24,130
Journal entry to change from FIFO to DVLIFO:
FIFO = $10,500, DVLIFO = $9,870:
(E)COGS$630
(A)Allowance to reduce FIFO to DVLIFO$630
To adjust FIFO to DVLIFO
(Note: just as in our simple M&M example, here we see that LIFO (even DVLIFO) will result in a smaller net income than FIFO when prices are rising)
1999 & 2000 repeat steps (let class do)
Summary of Steps for each year:
199819992000
- Convert ending inventory to base year dollars:$9,813 $10,045$10,435
- Compute change in terms of base year dollars: $813 $232$390
- Convert increase to current year dollars: $870 $259$449
- Add current year layer to beg. DV LIFO inventory$9,870 $10,129$10,578
- Calculate Cost of goods Sold$24,130 $19,741$19,551
Ending inventory is made up of the following layers (You have to keep track of the individual layers and the index that goes with each layer in case you have to do a LIFO liquidation in the future):
1997$9,000$9,000 $9,000
1998 870 870 870
1999 259 259
2000 449
DV LIFO questions(think about these!):
a)Where do the ending year $$ come from? These are the ending inventory balances under whatever method the firm uses internally (most likely FIFO or AVG cost)
b)Why is this method a shortcut? What do you need to know to compute DV LIFO? Only 3 things:
- Last year's DV LIFO schedules
- This year's ending inventory from your internal records
- This year's price index.
c)Where do the indexes come from? These are either developed in-house based on purchase prices or they are pulled from an external source - Consumer Price Index for example.
d)How does this relate to the LIFO we did earlier? The oldest costs are still the ones left on the balance sheet (remember the base year layer will stay until it is eaten away by lifo liquidations). The difference is that each year's additional layer is carried forward using its own original price index.
e)When firms use pools of inventory and DV LIFO, it reduces the chance of LIFO liquidations. Why? Primarily it is because big price swings in the price of individual products don't affect a pool of inventory as much (ex. 10 different products in one pool - the price swing of one is offset by the stability of the others so that the effect for the pool is minimized). So the greater the number of product types you have in each pool, the lower the probability of a liquidation.
f)Is a LIFO liquidation a net income increasing or a net income decreasing event (in a period where costs have been rising)? You can figure this out -- think about what would happen to your COGS if you eat into the old layers and use the old, lower costs on your income statement.
g)What might a wily manager do to the inventory pools if she needed to increase net income in a particular year? How might she increase the odds of an income increasing lifo liquidation? Think about it.
Other valuation methods:
Gross Margin method: NOT GAAP. Don't worry about this one (what a break!)
Retail Method: Acceptable under GAAP
This method is supposedly easier for retailers to use - why? We will see next time.
For your information:
The following is an example of a DV LIFO problem where we have a LIFO Liquidation. This example is provided for your benefit to refer back to in the future. Any DV LIFO problem or question on Exam 3 will NOT include this LIFO Liquidation issue. You might need to consider this for Supplemental 3.
Ruby keeps her inventory on a FIFO basis for internal recordkeeping. In 1998, she adopted LIFO for financial reporting purposes. Ruby has the following information regarding inventory balances for the last 3 years:
Ending Inventory(FIFO)Index
Balance, 12/31/97 (LIFO adoption year)$9,0001.00
Balance, 12/31/98 (at end of yr dollars)$10,5001.07
Balance, 12/31/99 (at end of yr dollars)$12,0001.12
Balance, 12/31/00 (at end of yr dollars)$9,2001.20
Purchases: 1998 $25,000
Purchases: 1999 $20,000
Purchases: 2000 $20,000
Summary of Steps for each year:
199819992000
- Convert ending inventory to base year dollars:$9,813$10,714$7,667
- Compute change in terms of base year dollars: $813 $901($3,048)
- Convert increase to current year dollars: $870$1,009 ($3,213)*
- Add current year layer to beg. DV LIFO inventory$9,870 $10,879$7,667
- Calculate Cost of goods Sold$24,130 $18,991$23,213
**Year 3 LIFO LIQUIDATION: We calculated the change in BASE year dollars so we need to eat into old layers at BASE year dollars (we have to use up the latest layers first) and convert the amount we use up into year specific dollars: Base Yr. Index Liquidation amt.
$$'sYR specific $$'s
1999 BASE year dollars available = $901, I need: -$9011.12-$1,009
1998 BASE year dollars available =$813, I need: -$8131.07-$870
1997 BASE year dollars available=$9,000, I need: -$1,3341.00-$1,334
Ties to year 3 step 1 above$10,714
DV LIFO Decrease for 2000: to yr 3 step 3-$3,213
LIFO layers carried forward:YEARINDEX199819992000
19971$9,000$9,000$7,667
1998 1.07 870 870 0
19991.12 1,009 0