Intermediate
Financial Accounting I
Inventories: Measurement
Objectives of this Chapter (contd.)
1. Identify the items that should be
included in the inventory count.
2. Discuss the lower of cost or market
(LCM) rule.
3. Study the accounting treatment of
changing to LIFO cost flow assumption
and the use of LIFO reserve account.
4. LIFO Inventory Pools
5. Dollar-value LIFO technique.
Inventories: Measurement
Objectives of this Chapter
1. Discuss the importance of inventory
valuation.
2. Study perpetual and periodic inventory
systems and the ending period
adjustments for inventory.
3. Study and compare the inventory cost
flow assumptions.
4. Explain the effect of LIFO liquidations.
Inventories: Measurement 2
1. Inventories:
the Importance of Inventory Valuation
How would the valuation and cost flow
assumptions of inventory affect the income
measurement?
Valuation Methods: Historical Cost,
Current Exist Value, Current Entry Value,
Present Value, LCM.
Cost Flow Assumptions: LIFO, FIFO,
Average, Specific Identification.
CGS = Beginning Inventory + Net
Purchase - Ending Inventory
3 Inventories: Measurement 4
Inventories: The Impact of Valuation of Ending
the Importance of Inventory Valuation (contd.) Inventory on The CGS & Income
Different valuation methods and Year 1
Income CGS = Beg. Inv. + Net Pur. - End. Inv.
different cost flow assumptions will
result in different cost of ending under over under a
over under over b
inventories and therefore different cost
of goods sold. Year 2
over under under
under over over
a. either understating the units or the value
b. either overstating the units or the value

Inventories: Measurement 5 Inventories: Measurement 6

Impact on Omitting Goods from

Defining Inventory
Purchases
CGS = Beg. Inventory + N.P. - End. Inventory 1. Assets held for resale purpose in a
normal course of business
B/S I/S
Ending Inv. understated Purchase understated
2. Assets used to produce products for
resale purpose
R/E no effect CGS no effect
A/P under N/I no effect Merchandising Firms: Inventories
Working Capital no effect Inventory (End.) understated Manufacturing Firms: Raw materials
Current Ratio overstatinga Work-in-process
a. When CA > CL Finished goods

Inventories: Measurement 7 Inventories: Measurement 8

Presentation of Inventory for Merchandising and Inventory Cost Flow (Illustration 8-3, KWW, 14 th

Manufacturing Companies (Illustration 8-1, KWW, 14th e) e)

Inventories: Measurement 9 Inventories: Measurement 10

How to Determine Inventory Value 2. Inventory Systems and

Presented on the Balance Sheet? Ending Period Adjustments
Applying either the periodic inventory Types of Inventory Systems
system or the perpetual inventory
system and select a cost flow A. Perpetual Inventory System
assumption to determine the value of B. Periodic Inventory System
inventories.
Both inventory systems require a
physical count of inventory at the end of
a period to determine the units which
can be included in the inventory account.
Inventories: Measurement 11 Inventories: Measurement 12
Comparing Perpetual and Periodic Comparative Entries- Perpetual vs. Periodic
Systems (Source: KWW, 14th e, p438) (Illustration 8-4, KWW, 14th e)

Assuming that Fesmire Company had the

following transactions during the current
year:
Inventory Units Unit Cost Total
Beginning Inv. 100 $6 $600

Purchases 900 $6 $5,400

Sales 600 $12 $7,200

Ending 400 $6 $2,400

Inventory
Inventories: Measurement 13 Inventories: Measurement 14

Perpetual Systems – Cost of Goods Sold and
the Ending Inventory
Since the inventory and the cost of
goods sold (CGS) accounts are
updated with all purchases and sales
transactions, the balances of these two
accounts are known at all time.
The CGS is determined by selecting a
cost flow assumption.
Perpetual Systems – Cost of Goods Sold
and the Ending Inventory (contd.)
Physical inventory count is still needed
at the end of a period to determine
whether inventory loss occurred.
A write down is required in the case of
inventory loss.

Inventories: Measurement 15 Inventories: Measurement 16

 Periodic Inventory System – the Ending
Inventory and the Cost of Goods Sold Inventory Cost Flow Assumptions
 For the periodic system, the inventory  Fist-In, First-Out (FIFO)
balance is only determined at the end of a  Last-In, First-Out (LIFO)
period after an inventory count and
applying a cost flow assumption.  Weighted-Average Cost (W-A)
 The cost of goods sold (CGS)is derived  Specific Identification
as: CGS = Beg. Inv. + Net purchases –
cost of ending inventory

Inventories: Measurement 17 Inventories: Measurement 18

Perpetual Inventory System - An Example (contd.) - Journal Entries

Example (Perpetual vs. Periodic)
Balance Perpetual (FIFO) Periodic
Date Purchase Sell FIFO W-A
LIFO 3/5 Inventory 900 3/5 Purchases 900
3/1 (Beg. Bal.) 100 $5 100 $5 100 $5 Cash 900 Cash 900
100 $5 100 $5 3/7 Cash 2,000 3/7 Cash 2,000
3/5 150 $6 250 $5.6 Sales Rev. 2,000 Sales Rev. 2,000
150 $6 150 $6
3/7 200a 50 $6 50 $5 50 $5.6 CGS 1,100
Inventory 1,100
50 $6 50 $5 3/14 Inventory 700 3/14 Purchases 700
3/14 100 $7 150 $6.53
100 $7 100 $7 Cash 700 Cash 700
20 $6 50 $5 3/28 Cash 330 Cash 330
3/28 30b 120 $6.53
100 $7 70 $7 Sales Rev. 330 Sales Rev. 330
a. Sales price is $10 per unit. CGS 180
b. Sales price is $11 per unit. Inventory 180
c.LIFO is not permiitted under IFRS
Inventories: Measurement 19 Inventories: Measurement 20
 Perpetual Inventory System Perpetual Inventory System
Example (contd.) Example (contd.)
The balance of cost of goods sold account1 :
Inventory a
Inventory Inventory
(FIFO) (LIFO) (WA)
CGS CGS CGS
B.B.500 1100 500 1150 500 1120 (FIFO) (LIFO) (W-A)
900 180 900 210 900 195.9 3/7...1100 1150 1120
700 700 700
3/28...180 210 195.9
E.B.820 740 784.1
1280 1360 1315.9
a. The balance of inventory is known at all time
under the perpetual inventory system. 1.The balance of inventory is known at all time
under the perpetual inventory system.
Inventories: Measurement 21 Inventories: Measurement 22

Ending Period Adjustments a. Adjustments for Lost Units

Perpetual Inventory System (Perpetual Inventory System)
Assuming ending units = 110 units.
a. Adjustments for lost units. On 3/31, the lost units = 10.
b. Adjustments for LCM valuation. Cost of 10 lost units => $6 x 10 = $60 (FIFO)
$7 x 10 = $70 (LIFO)
$6.53 x 10 = 65.3 (W-A)
Adjusting Entry:
3/31 Loss on Inventory Units a 60
Inventory 60
a. or use the account of Inventory over and short
Inventories: Measurement 23 Inventories: Measurement 24
b. Adjustments for LCM Valuation Adjustments for LCM Valuation
(Perpetual Inventory System) (contd.)
Inventory (FIFO) Adjusting entry => Given that Allowance for
Declining in Market Value of inventory has a
B.B 500 1,100 beginning balance of zero:
900 180
Allowance 3/31
700 0 -- 3/1 Loss Due to Market Value
820 60 -- 3/31 (Adj. for lost units) 160 Decline of Inventory 160
760 160 -- 3/31 Allowance to Reduce
Inventory to Market 160
B/S (3/31)
Ending Inv. Cost (on 3/31, FIFO) = $760 LCM Inventory 760
Assuming market price = $600 LCM = $600 =$600
Allowance (160)
Inv. At LCM 600
Inventories: Measurement 25 Inventories: Measurement 26

Adjustments for LCM Valuation Adjustments for LCM Valuation

(contd.) (contd.)
If the allowance account had a beginning If the Allowance account had a
balance of $20, the adjusting entry would beginning balance of 200, the adjusting
be: entry would be:
Allowance Allowance Allowance 40
20 -- 3/1 Loss 140
40 200 Gain from Recovery
140 Allowance 140
160 -- 3/31 160 of M.V. of Inventory 40

Inventories: Measurement 27 Inventories: Measurement 28

Periodic Inventory System
At the end of an accounting period, the
following steps must be followed to
determine the cost of ending inventory
and cost of goods sold:
1. Do an inventory count.
2. Applying a cost flow assumption to
determine the cost of ending inventory.
3. Determine the cost of goods sold using:
CGS = Beg. Inv. + Net Pur. - Ending Inv.a
a. No adjusting entries are required.
Inventories: Measurement
Periodic Inventory Systema : An Example
Using the example on Page 10 and
assuming the physical count of
inventory indicates 105 units on hand
on 3/31, the cost of ending inventory
(105 units) would be (given a FIFO
cost flow assumption):
$7 100 + $6 5 = $730
a. For journal entries, see page 20.
29 Inventories: Measurement 30

Periodic Inventory System Ending Period Adjustments

Example (contd.) (Periodic Inventory System)
Inventory Data: The CGS under FIFO is: 1. No adjustment is needed for lost units
Units Cost $500 + 1,600 - 730 = (because the cost of lost units is
3/1 (B.B) 100 $5 $1,370.
embedded in the CGS).
3/5 Pur. 150 $6 If a LIFO assumption is
3/14 Pur. 100 $7 used, the cost of end.
Inv. is:
$5 x 100 + $6 x 5 = $530.
The CGS is:
$500 + 1600 - 530 =
$1,570.
Inventories: Measurement 31 Inventories: Measurement 32
Ending Period Adjustments An Alternative of LCM Adjustment
(Periodic Inventory System)
2.Adjustment for the LCM valuation assuming  Many companies (i.e., Cisco Systems, inc. 2001,
FIFO: source: Spiceland, etc.)record the adjustment of
Cost of E.I. = $730 LCM Allowance LCM as follows:
Market = $600 = $600 0 -- Cost of Goods Sold 160
3/1(assumed)
130 Inventory 160
Adjusting entry: 130 --3/31  Note: Recording the loss as an increase in CGS will
have the same impact on earnings as reporting it as a
Loss Due to Market Decline of Inv. 130 loss from value decline in the holding inventory.
Allowance to Reduce Inv. to Market 130 However, this treatment will distort the cost of goods
sold and therefore, the gross profit..
Inventories: Measurement 33 Inventories: Measurement 34

Examples of Earnings Boosted by Selling

Inventory Which Had Been Written Down 3. Comparison of FIFO vs. LIFO
previously (Source: P500 of KWW, 14th e) During an Inflation Period
Company Gain from Disclosure
reversal Income Tax B/S I/S
Vishay Not Available Did not mention the gain in LIFO
Intertechnology its earnings release.. It
only disclosed this gain (matching
from write-down in two current cost
weeks later in its SEC
with revenue Low Low Unfair Fair
filing .
Similar to the case of
if not
Transwitch $600,000
Vishay depleted to
Cisco Systems $525 million Detailed in its earnings early layers)
releases and in SEC filings
the gains from selling FIFO High High Fair Unfair
inventory it had previously
written off.
35 Inventories: Measurement 36
Survey: (Source: Accounting Trends & Techniques Survey: (Source: Accounting Trends &
and footnote 16 of Chapter 8 , KWW 14th e) a, b,c
Techniques) (contd.)
Yearl Total LIFO FIFO W-A Others a. Sample firms are 600 firms. Most
1984 1061 408 38% 366 30% 225 22% 52 5%
companies adopt more than one
inventory method.
1988 1038 379 37% 396 38% 213 21% 50 5% b. Due to low inflation, the number of
1991 1032 361 35% 421 41% 200 19% 50 5% firms adopting LIFO has declined
since mid-1980s.
2000 887 283 32% 386 44% 180 20% 38 4%
c. IAS No. 2 does not permit LIFO, and
2006 802 228 28% 385 48% 159 20% 30 4% therefore, multinational companies
2010 666 176 26% 325 49% 147 22% 18 3%
use LIFO for all or most of their
domestic inventories while use FIFO
or average cost for their foreign
subsidiaies.
Inventories: Measurement 37 Inventories: Measurement 38

Switching to LIFO Income Manipulation When LIFO Is

During an Inflation Period Used (assuming price is rising)
Reason of switching to LIFO: 1. To increase income (by decreasing
Tax savings. CGS):
Strategy:
2.To decrease income (by increasing
CGS):
Strategy:

Inventories: Measurement 39 Inventories: Measurement 40

Advantages of FIFO
a. Less likely to be subject to
management manipulation;
b. Produce higher income during an
inflation period;
c. Inventory cost reported on the B/S is
close to the replacement cost.
Inventories: Measurement
Advantages of LIFO
a. Good match of sales revenue with
CGS.
b. Produce lower income during an
inflation period; result in tax savings.
Inventories: Measurement
Disadvantage of FIFO
a. Bad matches of sales revenue and
CGS; match current sales revenue with
old costs;
b. Producing higher income during an
inflation period results in paying more
income tax.
41 Inventories: Measurement 42
Disadvantages of LIFO
a. Inventory cost presented on the B/S is
not fair.
b. Subject to management manipulation.
Note: International Accounting Standard
No. 2 does not allow LIFO.
43 Inventories: Measurement 44
 IRS IRS (contd.)
1. Does not allow firms to use LCM if 3. LIFO is not acceptable by the IRS till
firms are using LIFO. 1939.

2. LIFO conformity rule.

The non-LIFO income numbers are
allowed on the supplementary reports
since 1981.

Inventories: Measurement 45 Inventories: Measurement 46

An Example of LIFO Liquidation

4. LIFO Liquidations
Profit
20x5 Beg. Inv. 400 $5
A LIFO Liquidation profit can occur Pur. 300 $6
when units purchased are less than Pur. 500 $7
units sold in the period. Pur. 600 $8
During 20x5, 1,700 units were sold.
What is the LIFO liquidation profit?
Total purchases of 20x5 are 1,400 units.
The LIFO liquidationprofit is:
(1,700-1,400) x ($8-$5) = $900

Inventories: Measurement 47 Inventories: Measurement 48

Choice of Inventory Cost-Flow Assumptions and
Conversion of FIFO to LIFO for Comparison
Purposes*
a. Choice of inventory cost-flow
assumptions.
b. Inventory Management (JIT system,
Inventory turnover rate, etc.): the
example of Dell Inc.
c. Adjustment of inventory cost-flow
assumption on the same basis before
making comparison of financial
statements.
Inventories: Measurement
Adjustment of Inventory Cost-Flow
Assumption- An Example (contd.)
CGS = Beg. Inv. + Net Pur. – End. Inv.
Impact => -1000 -3000
of LIFO
 Thus, the CGS of x 2 should be
increased by $2,000 when adopting
LIFO rather than FIFO.
 The income before tax would be
decreased by $2,000.
Inventories: Measurement
Adjustment of Inventory Cost-Flow
Assumption – An Example
Information: ABC is currently adopting
FIFO assumption. IF LIFO were
adopted, thecost of ending inventory
would be $1,000 and $3,000 lower for
x1 and x2, respectively.
Question: How much would the CGS and
income be different when LIFO is
adopted rather than FIFO for x2?
49 Inventories: Measurement 50
LIFO Reserve: An Account to Adjust Ending
Inventory Value from FIFO to LIFO
The difference in the inventory between
the inventory method used for internal
(i.e., FIFO) vs. external (i.e., LIFO)
reporting purposes is referred to as LIFO
Reserve or the Allowance to Reduce
Inventory to LIFO .
The change in the balance of LIFO
Reserve from one period to another is
referred as the LIFO Effect , an impact
on income.
51 Inventories: Measurement 52
LIFO Reserve – An Example
Assume that Acme Boot Company uses FIFO
method for internal reporting purposes and a
LIFO for external reporting purposes.
On 12/31/x5, the LIFO Reserve balance is
$20,000 and the value of ending inventory on
12/31/x6 under LIFO is $50,000 less than that
of FIFO.
Inventory on 12/31/x5 at FIFO = $320,000
Inventory on 12/31/x6 at FIFO =$360,000
Inventories: Measurement
LIFO Reserve - Example (contd.)
Journal Entry to adjust inventory from FIFO to
LIFO:
Cost of Goods Sold 30,000
LIFO Reserve a
(or Allowance to Reduce
Inventory to LIFO)
a. reported as a contra account to inventory
or a deduction from inventory (see p53 for
presentation)
Inventories: Measurement
LIFO Reserve – Example (contd.)
(Inventory Disclosure, note D)12/31/x6 12/31/x5
Inventory at FIFO $360,000 $320,000
LIFO Reserve (50,000) (20,000)
Inventory at LIFO $310,000 $300,000
Thus, $30,000 should be added to the
LIFO Reserve account. The LIFO effect
(i.e., the impact on income) for 20x6 is
53
$30,000. Inventories: Measurement 54
Inventory Presentation and Footnote
Disclosure (also see Illustration 8-19 of KWW, 14th e)
12/31/x6: Inventories, net of adjustment to
LIFO Reserve
(Note D) $310,000
30,000
Note D (contd.): Inventories. Inventories
are valued at the lower of cost or
market determined principally by the
LIFO method. If the FIFO cost
method had been used, inventories
55
would have been $50,000 higher.
Inventories: Measurement 56
Illustration 8-19 (KWW, 14th e)
Inventories: Measurement
Special Cases
a. Consigned Goods: Legal title
remained with the consignor
(manufacturers).
b. Sales with High Sales Returns
(conditional sale):
c. Sales on Approval:
Inventories: Measurement
5. Items to Be Included in Inventory
Any goods with the legal title transferred
to the buyer should be included in the
inventory of the buyer (including goods
in transit with a F.O.B. shipping point
term).
57 Inventories: Measurement 58
Special Cases (contd.)
d. Product Financing Arrangements:
Parking Transactions; sales with
buyback agreements.
e. Sales on Installment (revenue
recognition on accrual basis if
uncollectible amounts can be
estimated)
59 Inventories: Measurement 60
What Should Be Included in The What Should Be Included in the
Product Costs Product Costs (contd.)
Purchase price --> Yes Purchase Discount account should be
x --> No
Freight-In cost --> may be treated as a contra account to
x Handling charge purchases.
x Storage cost related to purchase
x Buying cost of the purchasing department
x Insurance, taxes
Interest cost: only in some cases.

Inventories: Measurement 61 Inventories: Measurement 62

6. Inventory Valuation - the LCM Rule Inventory Valuation - Example

Departure from Historical Cost Assumption
Selling price = 12
LCM: Lower of Cost or Market.
Package cost = $1
Reasons: Conservatism.
Transportation cost = $3
Market ==> Replacement Cost constrained by:
Ceiling => Net Realizable Value Normal profits = $3
= Selling price - estimated cost to
complete and sell NRV = Selling price - Package -
Floor => NRV - normal profits
Transportation = $12 - $1- $3 = $8
NRV - Normal profit = $5
 IFRS: Market is the NRV.
Inventories: Measurement 63 Inventories: Measurement 64
Inventory Valuation - Example (contd.) Inventory Valuation - LCM
Acquisition Replacement NRV - For financial reporting, LCM can be
NRV Market LCM
Cost Cost Profit performed at the individual item level, at the
$10 $6 $8 $5 $6 $6 category level or at the total inventory level.
a
$10 $9 $8 $5 $8 $8
b
Common practice: at the individual item
$10 $4 $8 $5 $5 $5 level.
$10 $12 $8 $5 $8 $8
LCM performed at the individual item level is
a. Example of the ceiling can prevent future most conservative and is most commonly
unexpected loss. used because it is complied with the IRS
b.Example of preventing the recognition of
abnormal loss in the current period. rule.
Inventories: Measurement 65 Inventories: Measurement 66

LCM Application - at Individual Level LCM and iGAAP

versus at Group Level
Item Cost Market LCM (at individual level) IAS No. 2 requires inventory to be valued
A $50 $60 $50 at LCM which can be applied at different
levels of inventory as in GAAP.
B* $140 $100 $100
C $300 $360 $300 The market value of IAS is the NRV, not
the replacement cost as in US GAAP.
Total _____
$490 _____
_____ $520
_____ $450
_____
_____ IAS allows the reversal of inventory write-
LCM at group level ==> $490
down when the conditions for write-down
do not exist.
The difference of $40 is resulting from item
B: $140 - 100 = $40 US GAAP does not allow the reversal of
Inventories: Measurement 67
inventory write-down.
Inventories: Measurement 68
7. Initial Adoption of LIFO
The accounting treatments for
accounting method changes are:
a. Current Period Approach: cumulative
effect from the change reported in the I/
S. (Note: eliminated by SFAS 154)
b. Retrospective Approach
Inventories: Measurement
Initial Adoption of LIFO
This value of the beginning inventory
needs to be adjusted to the cost.
The effect of the change on the current
year’s income and on the value of the
ending inventory must be disclosed.
Inventories: Measurement
Initial Adoption of LIFO
When change from other method to
LIFO, neither a cumulative effect nor a
retrospective adjustment can be made.
The base year inventory for all following
years is the beginning inventory of the
year In which LIFO is adopted.
69 Inventories: Measurement 70
Journal Entry to Restate
the Beginning Inventory to Cost
Assume that Rooms, Inc. decided to
switch from FIFO to LIFO in 20x9. The
beginning inventory of 20x9 has a cost
basis of $100,000 but is reported at
$90,000 on the balance sheet because
market is lower than cost. The
following entry is made to restate the
inventory to a cost basis (ignoring tax
effects):
71 Inventories: Measurement 72
Journal Entry to Restate the Journal Entry to Restate the
Beginning Inventory to Cost (contd.) Beginning Inventory to Cost (contd.)
Alternative 1: Alternative 2:
Allowance to Reduce Inventory 10,000
Inventory to Market 10,000
Adjustment to
Adjustment to Record Record Inv. at Cost 10,000
Inventory at cost 10,000
(only If a direct write-off method is used in
(If an allowance method is used in LCM LCM application)
application.)

Inventories: Measurement 73 Inventories: Measurement 74

Footnote Disclosure of Changing 8. LIFO Inventory Pools (Specific Goods

from FIFO to LIFO
Note: Inventory Pricing. In the fourth quarter, the
company expanded its use of the LIFO method
of inventory to additional portion of its
inventories in order to more closely match
current costs with current revenues. The effect
of this change was to reduce net income for the
current year by $2,804,000 or $0.49 per share.
As of December 31, inventories valued on a
LIFO basis amounted to $74,166,000. If valued
on a FIFO basis, such inventories would be
increased to $90,551,000.
Inventories: Measurement
Pooled LIFO) (source: Spiceland, etc.)*
 Problems associated with the Unit LIFO
(i.e., the LIFO concept applies to units of inventory
as described in previous sections; also called
specific goods LIFO):
 Costly to implement: It requires the
records of each unit of inventory.
 LIFO liquidations: When units of a
specific inventory purchased are less
than units sold during the period, the
beginning layers are eroded.
75 Inventories: Measurement 76
LIFO Inventory Pools (contd.)* LIFO Inventory Pools (contd.)
LIFO inventory pools technique can: Within pools, all purchases of goods in the
pool are considered to be made at the
1) simplify recordkeeping by grouping same time during the period and at the
inventory into pools, and average cost.
2)reduce the probability of LIFO layer When the quantity of ending inventory in
liquidation/erosion. the pool increases (i.e., the quantity of
ending inv. is greater than that of the beg.
Inv.), the ending inventory of the pool will
consist of the beg. Inv. and the layer of the
period.
Inventories: Measurement 77 Inventories: Measurement 78

LIFO Inventory Pools: An Example

LIFO Inventory Pools: An Example
(contd.) (skip 78-81)
The 2008 beg. inventory (BI)of Cole Glass Inc. During 20x8, Cole sold 48,000 squared feet
LIFO inventory pool consisted of the following: of window glass and purchased 51,000
Quantity (squared
foot (SF))
Cost (per
SF)
Total Cost squared feet as follows:
Quantity (squared Cost (per SF) Total Cost
foot (SF))
Grade A 10,000 $3.00 $30,000
Window Glass Grade A Window 20,000 $3.10 $62,000
Glass
Grade B 14,000 $2.50 $35,000 Grade B 15,000 $2.60 $39,000
Grade C 11,000 $2.20 $24,200 Grade C 16,000 $2.45 $39,200
Totals 35,000 $89,200 Totals 51,000 $140,200

Average SF Cost $2.55 = ($89,200/ Average 2008 SF $2.75 = ($140,200/

Cost of the Pool 51,000)
of the Pool -BI 35,000)
Inventories: Measurement 79 Inventories: Measurement 80
LIFO Inventory Pools: An Example
(contd.)
The average cost of 2008 beg. inventory
and 2008 window glass inventory pool is
$2.55 and $2.75, respectively.
The ending inventory quantity for the
pool is:
35,000+51,000-48,000=38,000 units
Inventories: Measurement
Problems Associated with LIFO
Inventory Pools
When a product in an inventory pool is
discontinued, the old costs of the
discontinued item will become the cost of
goods sold and therefore, result in LIFO
liquidation.
Even if the product is replaced, it may not be
similar to the old item and cannot be included
in the same pool.
Therefore, LIFO inventory pool requires
redefine pools periodically when there are
changes in the product mix of the pool. 83
Inventories: Measurement
LIFO Inventory Pools: An Example
(contd.)
Since the ending inventory of 2008
exceeds its beg. Inventory, the ending
inventory will include the beginning
inventory (i.e., 35,000 units ) and a LIFO
layer of 3,000 units from 2008 .
Thus, the cost of 2008 ending inventory
equals:
$2.55 x 35,000+ $2.75x 3,000 = $97,500
81 Inventories: Measurement 82
9. Dollar-Value LIFO (DV LIFO)
Technique*
DV LIFO technique simplifies the
recordkeeping procedures (due to no
need to keep unit flows).
DV LIFO technique helps to protect
LIFO layers from erosion (i.e., reduce the
probability of LIFO liquidations; more than
the LIFO inventory pool technique).
This technique is commonly used in
practice for companies adopting LIFO
assumption.. Inventories: Measurement 84
DV LIFO Technique (contd.)*
DV LIFO defines a layer as the dollar
value, not units, of ending inventory for a
specific year.
One layer is formed for each year.
Dollar Value of Inventories: Current cost
(the most recent purchase price) of the
ending Inventory.
Inventories: Measurement
DV LIFO Technique (contd.)*
To determine whether a new LIFO layer
is added under DV LIFO, the DV of
ending inventory (EI) is compared with
that of the beg. Inventory (BI).
If the DV of EI exceeds that of the BI,
the EI layers will consist of the DV of
the BI layer plus a new DV layer
created for the current year (i.e., the DV
of EI – the DV of BI).
85 Inventories: Measurement 86

The Cost Index Dollar Value LIFO – An Example

When the price level of the EI differs from Layer Current Cost Cost EI at Value of
that of BI, a cost index should be used to Year of Ending (Price) Base year Inv. At
adjust the DV of EI at the price level of the Inventory Index Price Levl. D-V LIFO
BI before forming the layers for the EI. 20x0 a $20,000 100 $20,000 $20,000
Cost index of a layer year = 20x1 $30,000 120 $25,000 $26,000
20x2 $35,100 130 $27,000 $28,600
Cost in layer year/Cost in base year
20x3 $40,600 140 $29,000 $31,400
 Base year is the year in which DV LIFO is
a. the base year
adopted and a layer year is any
subsequent year in which an inv. Layer is
created.. Inventories: Measurement 87 Inventories: Measurement 88
 Example (contd.) Comments on Dollar-Value LIFO
Forming of layers:
20x0 20x1 20x2 20x3 Items with similar economic, not
20,000 ... L1 20,000...L1 20,000...L1 20,000...L1 physical, characteristics (i.e., subject to
5,000...L2 5,000...L2 5,000...L2 similar cost change pressure) will be
2,000...L3 2,000...L3
2,000 ..L4 pooled together.
Converting to the corresponding year’s index level: The more items are included in an
20x0 20x1 20x2 20x3
inventory pool, the less likely the
20,000x1 20, 000x1+ 20,000x1+ 20,000x1+ erosion of the LIFO layers can occur.
=20,000 5 ,000x1.2 5,000x1.2+ 5,000x1.2+
=26,000 2,000x1.3 2,000x1.3+
Inventories:=28.600
Measurement 2,000x1.489 Inventories: Measurement 90
=31,400

Comments on Dollar-Value LIFO An Example of Manipulating Income by

(contd.)* Changing the Number of Inventory Pools
Income number can be manipulated by Stauffer Chemical Company had
changing the number of inventory increased LIFO pools from 8 to 280 ,
pools. boosting its net income by $16,515,000
(13%) (source: KWW, 14th edition, p461).
On average, retailers form 6 pools for
their inventories and non-retailers form
3 pools for their inventories with about a
third of non-retailers use a single pool.
(source: footnote 6 of chapter 8, KWW, 14th e).
Inventories: Measurement 91 Inventories: Measurement 92
Types of Indexes
Internal Index: Internal price index
computed by the company for its own
product.
External Index: Computed by an outside
party such as the government, commodity
exchange, or trade association.
General Index: Composed of several
commodities, goods or services.
Specific Index: For one commodity, good
or service.
Inventories: Measurement
External Price Index*
The Consumer Price Index for urban
consumers (CPI-U) is an example of an
external general price index.
CPI-U is published monthly by the Bureau of
Labor Statistics of the federal government.
Specific external price indexes (i.e., for gold,
silver, corn…) are also available from trade
associations.
93 Inventories: Measurement 94

The Internal Indexes Example

A Double-Extension Method (i.e., the value To compute specific internal price indexes:
of inv. units extended at both current and base-year Year Current Units of Cost
prices): Cost End. Inv. Index(%)
20x0 (base year) $19 300 100a
Internal Index for the Current Year = 20x1 $22.8 400 120b
End. Inv*. at Current Year’s Cost 20x2 $24.7 450 130c
End. Inv. at Base-Year Cost 20x3 $26.6 370 140d

End. Inv. is the ending inventory of the a. 19*300/19.0*300=100% c.24.7*450/19*450=130%

current year. b. 22.8*400/19*400=120% d.26.6*370/19*370=140%
The cost index for the base year equals one.
Inventories: Measurement 95 Inventories: Measurement 96
Example (contd.)
General internal price index:
(for more than one inventory in the pool):
Inv. A Inv. B
Current Units of Current Units of
Cost End. Inv. Cost End. Inv.
20x0(base year) $19 100 $20 150
20x1 $22.8 110 $22 120
General internal price index of 20x0:
(19x100+20x150) / (19x100+20x150)=100%
General internal price index of 20x1:
(22.8x110+22x120) / (19x110+20x120)=114.6%
Inventories: Measurement 97