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    Inventories: Measurement: Methods of Simplifying Lifo LIFO Reserve

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    Steeeeeeeeph
    This document discusses methods for simplifying the last-in, first-out (LIFO) inventory costing method. It describes establishing a LIFO reserve to account for differences between internal and external reporting values. It also discusses grouping inventory into pools and using dollar-value LIFO, which measures inventory based on constant dollars rather than physical quantities. An example is provided to illustrate how dollar-value LIFO accounting works over multiple years, including building new LIFO layers and partially liquidating existing layers.

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    Inventories: Measurement: Methods of Simplifying Lifo LIFO Reserve

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    Steeeeeeeeph
    23 views3 pages
    This document discusses methods for simplifying the last-in, first-out (LIFO) inventory costing method. It describes establishing a LIFO reserve to account for differences between internal and external reporting values. It also discusses grouping inventory into pools and using dollar-value LIFO, which measures inventory based on constant dollars rather than physical quantities. An example is provided to illustrate how dollar-value LIFO accounting works over multiple years, including building new LIFO layers and partially liquidating existing layers.

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    ACCTG

    Original Title

    C8B LIFO

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    This document discusses methods for simplifying the last-in, first-out (LIFO) inventory costing method. It describes establishing a LIFO reserve to account for differences between internal and external reporting values. It also discusses grouping inventory into pools and using dollar-value LIFO, which measures inventory based on constant dollars rather than physical quantities. An example is provided to illustrate how dollar-value LIFO accounting works over multiple years, including building new LIFO layers and partially liquidating existing layers.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    23 views3 pages

    Inventories: Measurement: Methods of Simplifying Lifo LIFO Reserve

    Uploaded by

    Steeeeeeeeph
    This document discusses methods for simplifying the last-in, first-out (LIFO) inventory costing method. It describes establishing a LIFO reserve to account for differences between internal and external reporting values. It also discusses grouping inventory into pools and using dollar-value LIFO, which measures inventory based on constant dollars rather than physical quantities. An example is provided to illustrate how dollar-value LIFO accounting works over multiple years, including building new LIFO layers and partially liquidating existing layers.

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    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:

    Change from
    Year Current $ Price Index Base-Year $ Prior Year
    1999 190,000 1.00 190,000
    2000 210,000 1.07 196,262 6,262
    2001 220,000 1.15 191,304 (4,957)
    2002 240,000 1.20 200,000 8,696

    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.

    F:\Teaching\3321\web\module4\c8\tnotes\c8b.doc 3/12/2007 1
    Inventories: Measurement

    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.

    Ending Inventory using Dollar-Value LIFO


    Year Base-Year $ Price Index Amount
    1999 190,000 1.00 190,000

    2000 190,000 1.00 190,000


    6,262 1.07 6,700
    196,262 196,700

    2001 190,000 1.00 190,000


    1,304 1.07 1,396
    191,304 191,396

    2002 190,000 1.00 190,000


    1,304 1.07 1,396
    8,696 1.20 10,435
    200,000 201,830

    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

    F:\Teaching\3321\web\module4\c8\tnotes\c8b.doc 3/12/2007 2
    Inventories: Measurement

    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.

    F:\Teaching\3321\web\module4\c8\tnotes\c8b.doc 3/12/2007 3

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