Inventories: Measurement
METHODS OF SIMPLIFYING LIFO
LIFO Reserve
Companies that use LIFO for tax and financial reporting many times maintain their internal records using one of the more conservative cost flow assumptions. This results in a difference between the internal books and external reporting. To account for this difference the company will establish a LIFO reserve account that adjusts the book inventory to LIFO at the end of the accounting period. A change in the reserve account at the end of the year is called the LIFO effect. If the value of inventory valued at LIFO decreases during the year this is called LIFO liquidation. It is possible for one or more LIFO layers (years) to be liquidated an accounting period. Once a layer is liquidated it can never be reestablished. The establishment of a LIFO layer can only take place in the current year.
LIFO Inventory Pools
Rather than accounting for each type of inventory separately, inventory items with similar qualities can be grouped together into an inventory pool. This reduces the amount of bookkeeping and smoothes out the fluctuations in LIFO layers from one year to the next.
Dollar-Value LIFO
Dollar-Value LIFO is the most widely used method. It is measured based on constant dollars rather that the physical quantity of goods in an inventory pool. A new LIFO layer is established only when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices.
Example: Spencer Company uses dollar-value LIFO for computing inventory. The following data for the past four years is as follows:
At the end of each year a physical count of inventory is taken and priced at current year dollars. In 1999, the first year of LIFO the first LIFO layer is established and the index is set. The 1999 layer at base-year dollars is $190,000.
In 2000 the company counted and priced its inventory using 2000 dollars. This inventory was then converted to base-year pricing by dividing the $210,000 current-year amount by 1.07, the index for 2000. We have an increase in inventory in 2000 of $6,262 based on the base-year pricing. This means that we have established a year 2000 LIFO layer of $6,262, which then needs to be converted to 2000 dollars. The year 2000 LIFO layer is thus priced out at $6,700 ($6,262 * 1.07). As long as inventory continues to increase based on base-year dollars this LIFO layer will stay in place.
In 2001 we see that this is not the case. There has been a reduction in inventory, which means that the 2000 LIFO layer is partially liquidated. The following demonstrates this liquidation.
As a result of the partial LIFO liquidation in 2000 the remaining LIFO layer for that year is now $1,396. We can never restore the amount that was liquidated.
In 2002 there was a new LIFO layer built. As you can see from the schedule above the base year dollar value of the 2002 LIFO layer was $8,696. This will be valued as part of the ending inventory at $10,435 ($8,696 * 1.20).
Advantages of LIFO Approaches
There are several advantages to the use of LIFO especially during times of inflation.
· Matching Principle
During times of high inflation the LIFO method does a better job of matching the cost of goods sold with revenue.
· Tax Benefits
The use of LIFO results in a higher cost of goods sold. This reduces taxable income and thus income taxes.
· Improved Cash Flow
Income taxes have to be paid in cash so the reduced taxes result in increased cash flow.
· Future Earnings Hedge
Because the company is using current dollars to value inventory is it unlikely that there will ever have to be a lower of cost or market adjustment to the ending inventory.
Disadvantages of LIFO Approaches
· Reduced Earnings
Depending on managements objectives it may not be advantageous for the company to have reduced earnings as a result of using LIFO. If the company is dependent on outside financing the build up of retained earnings may be a more important objective.
· Inventory Understated
The primary disadvantage of using the LIFO method is that inventory is materially understated in the balance sheet. Over the years this amount can become substantial. This is a major distortion of the balance sheet..
· Physical Flow
In most cases the LIFO does not come close to matching the physical flow of goods.
· Involuntary Liquidation
If prior layers or a portion of the base LIFO layer are liquidated the cost of goods sold becomes extremely distorted. We are now matching extremely old costs against current revenues. These unintended consequences can have both a tax impact and financial results that will need explanation.
· Poor Buying Habits
To prevent unexpected LIFO layer liquidations management may become sloppy is purchasing, erring on the side of caution so that a LIFO layer is not accidentally liquidated.
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