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.

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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

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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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