CHAPTER 8CONTINUED

VALUATION OF INVENTORIES: A COST-BASIS APPROACH

Sommers – ACCT 3311

Discussion Question

Explain why proponents of LIFO argue that it provides a better match of revenue and expenses. In what situation would it not provide a better match?

Discussion Questions

Q8–18 Explain the following terms:

(a) LIFO Layer

(b) LIFO Reserve

(c) LIFO Effect

Simplifying LIFO with LIFO Inventory Pools

• The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation.

• For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on.

• LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately.

Dollar Value LIFO (DVL)

• DVL extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool. Physical units are not used in calculating ending inventory. The technique helps companies simplify LIFO record-keeping, it also minimizes the probability of layer liquidation. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory. When using DVL we think in terms of inventory layers rather than inventory pools.

• The goal of DVL is to determine if an increase in ending inventory over beginning inventory is due to a price increase of a real increase in inventory.

Dollar-Value LIFO (DVL)

Cost index in layer

year =

Cost in layer year

÷Cost in base year

1a. Compute a Cost Index for the year.

1b. Deflate the ending inventory value using the cost index.

1c. Compare ending inventory (at base year cost) to beginning inventory.

Ending inventory at base

year cost

=Ending

inventory cost

÷Cost index

Change in inventory

=Ending Inv.

at base year cost

–Beg.

inventory

Dollar-Value LIFO (DVL)

2. Next, identify the layers in ending inventory and the years they were created.

3. Convert each layer’s base year cost to layer year cost by multiplying times the cost index.

4. Sum all the layers to arrive at Ending Inventory at DVL cost.

You are totally lost so let’s do this!

Example 2: Dollar Value LIFO Method

On January 1, 2011, the Taylor Company adopted the dollar-value LIFO method. The inventory value for its one inventory pool on this date was $400,000. Inventory data for 2011 through 2013 are as follows:

Calculate Taylor’s ending inventory for 2011, 2012, and 2013.

DateEnding Inventory at

Year-End CostsCost Index

12/31/11 $ 441,000 1.05

12/31/12 487,200 1.12

12/31/13 510,000 1.20

Example 2: Continued

Adjust 2011 inventory to 2010 base-year prices:

Calculate current year LIFO layer:

Add the new LIFO layer at end of period prices to prior year LIFO inventory:

Example 2: Continued

Adjust 2012 inventory to 2010 base-year prices:

Calculate current year LIFO layer:

Add the new LIFO layer at end of period prices to prior year LIFO inventory:

Example 2: Continued

Adjust 2013 inventory to 2010 base-year prices:

$510,000 / 1.20 = $425,000

Calculate current year LIFO layer:

$425,000 – $435,000 = ($10,000) Layer liquidation

Calculate LIFO layers at end of period prices:

$400,000 * 1.00 = $400,000

20,000 * 1.05 = 21,000

5,000 * 1.12 = 5,600

$426,600

LIFO Liquidation

Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes.

• Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2012, with cost determined on a specific-goods LIFO approach.

At the end of 2013, only 6,000 pounds of steel remained in inventory.

LIFO Liquidation Example Continued

LIFO Liquidation

When prices rise ...• LIFO inventory costs in the balance sheet are “out of

date” because they reflect old purchase transactions.• If inventory declines, these “out of date” costs may be

charged to current earnings.• This LIFO liquidation results in “paper profits.”

Could this be a source of abuse?

Example 3: LIFO Liquidation

The Reuschel Company began 2011 with inventory of 10,000 units at a cost of $7 per unit. During 2011, 55,000 units were purchased for $8.50 each. Sales for the year totaled 54,000 units leaving 11,000 units on hand at the end of 2011. Reuschel uses a periodic inventory system and the LIFO inventory cost method. Calculate cost of goods sold for 2011.

Cost of goods sold:

Units

10,000 55,000

65,000

11,000 54,000

Dollars

70,000 467,500

537,500

? ?

Example 3: LIFO Liquidation Continued

The Reuschel Company began 2011 with inventory of 10,000 units at a cost of $7 per unit. During 2011, 50,000 units were purchased for $8.50 each. Sales for the year totaled 54,000 units leaving 6,000 units on hand at the end of 2011. Reuschel uses a periodic inventory system and the LIFO inventory cost method. Calculate cost of goods sold for 2011.

Cost of goods sold:

Units

10,000 50,000

60,000

6,000 54,000

Dollars

70,000 425,000

495,000

? ?

Example 3: LIFO Liquidation Continued

From a financial reporting perspective, what problem is created by the use of LIFO in this situation? Describe the disclosure required to report the effects of this problem.

When inventory quantity declines during a period, liquidation of LIFO inventory layers carried at lower costs prevailing in prior years results in noncurrent costs being matched with current selling prices. If the resulting effect on income is material, it must be disclosed. In this case, the effect of the LIFO layer liquidation is to increase income (ignoring taxes) by $6,000 [4,000 units liquidated x $1.50 ($8.50 current year cost per unit - $7 LIFO layer cost per unit)].

Decision Makers’ Perspective

Factors Influencing Method Choice

• How closely do reported costs reflect actual flow of inventory?

• How well are costs matched against related revenues?

• How are income taxes affected by inventory method choice?

Matching

Tax Benefits/Improved Cash Flow

Future Earnings Hedge

Advantages

Reduced Earnings

Inventory Understated

Physical Flow

Involuntary Liquidation / Poor Buying Habits

Disadvantages

LIFO

LIFO is generally preferred:

1. if selling prices are increasing faster than costs and

2. if a company has a fairly constant “base stock.”

LIFO is not appropriate:

1. if prices tend to lag behind costs,

2. if specific identification traditionally used, and

3. when unit costs tend to decrease as production increases.

Basis for Selection of Inventory Method

When Prices Are Rising . . .

LIFO• Matches high (newer)

costs with current (higher) sales.

• Inventory is valued based on low (older) cost basis.

• Results in lower taxable income.

FIFO• Matches low (older)

costs with current (higher) sales.

• Inventory is valued at approximate replacement cost.

• Results in higher taxable income.

Example 1: Summary of Results

Cost ofGoods Sold

EndingInventory

FIFO, Periodic $75,000 $78,000

Avg Cost, Periodic 81,000 72,000

LIFO, Periodic 87,000 66,000

Costs were rising.If costs are falling, ordering is opposite.

Quality of Earnings

Changes in the ratios we have discussed often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income).

Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.