1. Acct Class 13
Chapter 8 CONTINUED VALUATION OF INVENTORIES: A COST-BASIS APPROACH Sommers – ACCT 3311
Chapter 1: Environment and Theoretical Structure of Financial Accounting.

2. 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?

3. Discussion Questions
Q8–18 Explain the following terms: (a) LIFO Layer (b) LIFO Reserve (c) LIFO Effect

4. 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.
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.

5. 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.

6. Dollar-Value LIFO (DVL)
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.
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. The first step in the process is to computer the cost index. This can be done in a number of ways. One method is shown on your screen, others include the use of industry specific general price indexes.

7. Dollar-Value LIFO (DVL)
Next, identify the layers in ending inventory and the years they were created.
Convert each layer’s base year cost to layer year cost by multiplying times the cost index.
Sum all the layers to arrive at Ending Inventory at DVL cost.
You are totally lost so let’s do this!
Finally, we convert the year’s layer into end of period dollars and add the adjusted layer to the beginning inventory. We always keep the beginning inventory and layers created in subsequent years separately. Let’s look at an example.

8. 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.
Date
Ending Inventory at Year-End Costs
Cost Index
12/31/11
$ 441,000
1.05
12/31/12
487,200
1.12
12/31/13
510,000
1.20

9. 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:

10. 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:

11. 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

12. 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.

13. LIFO Liquidation Example Continued
At the end of 2013, only 6,000 pounds of steel remained in inventory.

14. 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?
LIFO inventory liquidation usually happens in periods of rising prices when the inventory is on the balance sheet at lower prices. So, when inventory is reduced (liquidated) the cost of goods sold would be at older lower prices creating increase profits. We know that LIFO inventories contain old costs and these old costs really do not reflect replacement cost of the item in inventory. If inventories physically decline, these older, or out of date, costs may be charged against current earnings resulting in what we refer to as “LIFO liquidation profit.” A material effect on net income of LIFO layer liquidation must be disclosed in a note to the financial statements.

15. 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 Reuschel uses a periodic inventory system and the LIFO inventory cost method. Calculate cost of goods sold for Cost of goods sold:
Units
10,000
55,000
65,000
11,000
54,000
Dollars
70,000
467,500
537,500 ?

16. 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 Reuschel uses a periodic inventory system and the LIFO inventory cost method. Calculate cost of goods sold for Cost of goods sold:
Units
10,000
50,000
60,000
6,000
54,000
Dollars
70,000
425,000
495,000 ?

17. 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)].

18. 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?
A company is free to select its inventory costing method, but once selected, it should stay with that method. Some of the factors to consider when selecting an inventory costing method are: how closely does the method reflect the actual cost of inventory flow; how are income taxes affected by inventory method choice?

19. LIFO Advantages Disadvantages Matching Reduced Earnings
Tax Benefits/Improved Cash Flow
Future Earnings Hedge
Reduced Earnings
Inventory Understated
Physical Flow
Involuntary Liquidation / Poor Buying Habits

20. Basis for Selection of Inventory Method
LIFO is generally preferred:
if selling prices are increasing faster than costs and
if a company has a fairly constant “base stock.”
LIFO is not appropriate:
if prices tend to lag behind costs,
if specific identification traditionally used, and
when unit costs tend to decrease as production increases.

21. When Prices Are Rising . . . FIFO
Matches low (older) costs with current (higher) sales.
Inventory is valued at approximate replacement cost.
Results in higher taxable income.
LIFO
Matches high (newer) costs with current (higher) sales.
Inventory is valued based on low (older) cost basis.
Results in lower taxable income.
Under the FIFO system, inventory is valued at approximate replacement cost. Under LIFO, inventory is valued at oldest costs. In a period of rising prices FIFO results in higher taxable income, and LIFO results in lower taxable income.

22. Example 1: Summary of Results
Cost of
Goods Sold
Ending
Inventory
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.

23. 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.
Changes in the ratios we discussed above 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.