Download Inventories: Measurement

Intermediate
Financial Accounting I
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
Objectives of this Chapter (contd.)
5. Identify the items that should be
included in the inventory count.
6. Discuss the lower of cost or market
(LCM) rule.
7. Study the accounting treatment of
changing to LIFO cost flow assumption
and the use of LIFO reserve account.
8. LIFO Inventory Pools
9. Dollar-value LIFO technique.
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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

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Inventories:
the Importance of Inventory Valuation (contd.)

Different valuation methods and
different cost flow assumptions will
result in different cost of ending
inventories and therefore different cost
of goods sold.
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The Impact of Valuation of Ending
Inventory on The CGS & Income
Year 1
Income CGS = Beg. Inv. + Net Pur. - End. Inv.
under
over
under a
over
under
over b
Year 2
over
under
under
over
under
over
a. either understating the units or the value
b. either overstating the units or the value
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Impact on Omitting Goods from
Purchases
CGS = Beg. Inventory + N.P. - End. Inventory
B/S
Ending Inv.
understated
R/E
no effect
A/P
under
Working Capital no effect
Current Ratio overstatinga
I/S
Purchase
understated
CGS
no effect
N/I
no effect
Inventory (End.) understated
a. When CA > CL
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Defining Inventory
1. Assets held for resale purpose in a
normal course of business
2. Assets used to produce products for
resale purpose
 Merchandising
Firms: Inventories
 Manufacturing Firms: Raw materials
Work-in-process
Finished goods
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Presentation of Inventory for Merchandising and
Manufacturing Companies (Illustration 8-1, KWW, 14th e)
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Inventory Cost Flow (Illustration 8-3, KWW, 14
th
e)
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10
How to Determine Inventory Value
Presented on the Balance Sheet?


Applying either the periodic inventory
system or the perpetual inventory
system and select a cost flow
assumption to determine the value of
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.
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2. Inventory Systems and
Ending Period Adjustments

Types of Inventory Systems

A. Perpetual Inventory System

B. Periodic Inventory System
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Comparing Perpetual and Periodic
Systems (Source: KWW, 14th e, p438)


Assuming that Fesmire Company had the
following transactions during the current
year:
Inventory
Units
Unit Cost
Beginning Inv.
100
$6
$600
Purchases
900
$6
$5,400
Sales
600
$12
$7,200
Ending
Inventory
400
$6
$2,400
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Total
13
Comparative Entries- Perpetual vs. Periodic
(Illustration 8-4, KWW, 14th e)
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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.
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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.
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Periodic Inventory System – the Ending
Inventory and the Cost of Goods Sold
 For the periodic system, the inventory
balance is only determined at the end of a
period after an inventory count and
applying a cost flow assumption.
 The cost of goods sold (CGS)is derived
as: CGS = Beg. Inv. + Net purchases –
cost of ending inventory
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Inventory Cost Flow Assumptions
 Fist-In, First-Out (FIFO)
 Last-In, First-Out (LIFO)
 Weighted-Average Cost (W-A)
 Specific Identification
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Perpetual Inventory System - An
Example
Date
Purchase Sell
3/1 (Beg. Bal.)
3/5
150 $6
3/7
3/14
3/28
200
a
100 $7
30b
a. Sales price is $10 per unit.
b. Sales price is $11 per unit.
c.LIFO is not permiitted under IFRS
Balance
FIFO
LIFO
100 $5
100 $5
150 $6
50 $6
50 $6
100 $7
20 $6
100 $7
W-A
100 $5
100 $5
100 $5
250 $5.6
150 $6
50 $5
50 $5.6
50 $5
150 $6.53
100 $7
50 $5
120 $6.53
70 $7
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Example (contd.) - Journal Entries
(Perpetual vs. Periodic)
Perpetual (FIFO)
3/5 Inventory 900
Cash
900
3/7 Cash
2,000
Sales Rev. 2,000
CGS
1,100
Inventory 1,100
3/14 Inventory 700
Cash
700
3/28 Cash
330
Sales Rev.
330
CGS
180
Inventory
180
Periodic
3/5 Purchases
900
Cash
900
3/7 Cash
2,000
Sales Rev. 2,000
3/14 Purchases 700
Cash
700
Cash
330
Sales Rev.
330
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Perpetual Inventory System
Example (contd.)
Inventory a
(FIFO)
B.B.500 1100
900 180
700
E.B.820
Inventory
(LIFO)
500 1150
900
210
700
740
Inventory
(WA)
500
1120
900
195.9
700
784.1
a. The balance of inventory is known at all time
under the perpetual inventory system.
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Perpetual Inventory System
Example (contd.)
The balance of cost of goods sold account1 :
CGS
(FIFO)
3/7...1100
3/28...180
1280
CGS
(LIFO)
1150
210
1360
CGS
(W-A)
1120
195.9
1315.9
1.The balance of inventory is known at all time
under the perpetual inventory system.
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Ending Period Adjustments
Perpetual Inventory System
a. Adjustments for lost units.
b. Adjustments for LCM valuation.
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a. Adjustments for Lost Units
(Perpetual Inventory System)
Assuming ending units = 110 units.
On 3/31, the lost units = 10.
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
Inventory
60
60
a. or use the account of Inventory over and short
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b. Adjustments for LCM Valuation
(Perpetual Inventory System)
Inventory (FIFO)
B.B 500
1,100
900
180
700
820
60 -- 3/31 (Adj. for lost units)
760
Ending Inv. Cost (on 3/31, FIFO)
= $760
Assuming market price = $600 LCM = $600
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LCM
=$600
25
Adjustments for LCM Valuation
(contd.)

Adjusting entry => Given that Allowance for
Declining in Market Value of inventory has a
beginning balance of zero:
Allowance
0 -- 3/1
160
160 -- 3/31
B/S (3/31)
Inventory
Allowance
Inv. At LCM
3/31
Loss Due to Market Value
Decline of Inventory
160
Allowance to Reduce
Inventory to Market 160
760
(160)
600
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Adjustments for LCM Valuation
(contd.)

If the allowance account had a beginning
balance of $20, the adjusting entry would
be:
Allowance
20 -- 3/1
Loss
140
140
Allowance
140
160 -- 3/31
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Adjustments for LCM Valuation
(contd.)

If the Allowance account had a
beginning balance of 200, the adjusting
entry would be:
Allowance
40 200
160
Allowance
40
Gain from Recovery
of M.V. of Inventory
40
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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.
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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.
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Example (contd.)
Inventory Data:
Units
3/1 (B.B) 100
3/5 Pur. 150
3/14 Pur. 100
Periodic Inventory System
The CGS under FIFO is:
Cost $500 + 1,600 - 730 =
$1,370.
$5
$6
If a LIFO assumption is
used, the cost of end.
$7
Inv. is:
$5 x 100 + $6 x 5 = $530.
The CGS is:
$500 + 1600 - 530 =
$1,570.
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Ending Period Adjustments
(Periodic Inventory System)
1. No adjustment is needed for lost units
(because the cost of lost units is
embedded in the CGS).
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Ending Period Adjustments
(Periodic Inventory System)
2.Adjustment for the LCM valuation assuming
FIFO:
Cost of E.I. = $730
Market
= $600
3/1(assumed)
LCM
= $600
Allowance
0 -130
130 --3/31
Adjusting entry:
Loss Due to Market Decline of Inv.
Allowance to Reduce Inv. to Market
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130
130
33
An Alternative of LCM Adjustment
 Many companies (i.e., Cisco Systems, inc. 2001,
source: Spiceland, etc.)record the adjustment of
LCM as follows:
Cost of Goods Sold
160
Inventory
160
 Note: Recording the loss as an increase in CGS will
have the same impact on earnings as reporting it as a
loss from value decline in the holding inventory.
However, this treatment will distort the cost of goods
sold and therefore, the gross profit..
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Examples of Earnings Boosted by Selling
Inventory Which Had Been Written Down
previously (Source: P500 of KWW, 14th e)
Company
Gain from
reversal
Disclosure
Vishay
Intertechnology
Not Available
Did not mention the gain in
its earnings release.. It
only disclosed this gain
from write-down in two
weeks later in its SEC
filing .
Transwitch
$600,000
Similar to the case of
Vishay
Cisco Systems
$525 million
Detailed in its earnings
releases and in SEC filings
the gains from selling
inventory it had previously
written off.
35
3. Comparison of FIFO vs. LIFO
During an Inflation Period
Income
Tax
B/S
I/S
LIFO
(matching
current cost
with revenue
if not
depleted to
early layers)
Low
Low
Unfair
Fair
FIFO
High
High
Fair
Unfair
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Survey: (Source: Accounting Trends & Techniques
and footnote 16 of Chapter 8 , KWW 14th e) a, b,c
Yearl Total
1984 1061
LIFO
408 38%
FIFO
366 30%
W-A
225 22%
Others
52 5%
1988 1038
379 37%
396 38%
213 21%
50 5%
1991 1032
361 35%
421 41%
200 19%
50 5%
2000
887
283 32%
386 44%
180 20%
38 4%
2006
802
228 28%
385 48%
159 20%
30 4%
2010
666
176 26%
325 49%
147 22%
18 3%
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Survey: (Source: Accounting Trends &
Techniques) (contd.)
a. Sample firms are 600 firms. Most
companies adopt more than one
inventory method.
b. Due to low inflation, the number of
firms adopting LIFO has declined
since mid-1980s.
c. IAS No. 2 does not permit LIFO, and
therefore, multinational companies
use LIFO for all or most of their
domestic inventories while use FIFO
or average cost for their foreign
subsidiaies.
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Switching to LIFO
During an Inflation Period

Reason of switching to LIFO:
Tax savings.
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Income Manipulation When LIFO Is
Used (assuming price is rising)
1. To increase income (by decreasing
CGS):
Strategy:
2.To decrease income (by increasing
CGS):

Strategy:
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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.
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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.
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Advantages of LIFO
a. Good match of sales revenue with
CGS.
b. Produce lower income during an
inflation period; result in tax savings.
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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.
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IRS
1. Does not allow firms to use LCM if
firms are using LIFO.
2. LIFO conformity rule.
The non-LIFO income numbers are
allowed on the supplementary reports
since 1981.
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IRS (contd.)
3. LIFO is not acceptable by the IRS till
1939.
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4. LIFO Liquidations

A LIFO Liquidation profit can occur
when units purchased are less than
units sold in the period.
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An Example of LIFO Liquidation
Profit
20x5 Beg. Inv.
Pur.
Pur.
Pur.
400
300
500
600
$5
$6
$7
$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
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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.
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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?
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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.
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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.
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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
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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
$30,000.
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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)
30,000
a. reported as a contra account to inventory
or a deduction from inventory (see p53 for
presentation)
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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
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
would have been $50,000 higher.
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Illustration 8-19 (KWW,
th
14
Inventories: Measurement
e)
57
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).
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Special Cases
a. Consigned Goods: Legal title
remained with the consignor
(manufacturers).
b. Sales with High Sales Returns
(conditional sale):
c. Sales on Approval:
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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)
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60
What Should Be Included in The
Product Costs
 --> Yes
 Purchase price
x --> No
 --> may be
 Freight-In cost
x Handling charge
x Storage cost related to purchase
x Buying cost of the purchasing department
x Insurance, taxes
 Interest cost: only in some cases.
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What Should Be Included in the
Product Costs (contd.)

Purchase Discount account should be
treated as a contra account to
purchases.
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6. Inventory Valuation - the LCM Rule
Departure from Historical Cost Assumption
LCM: Lower of Cost or Market.
Reasons: Conservatism.
Market ==> Replacement Cost constrained by:
Ceiling => Net Realizable Value
= Selling price - estimated cost to
complete and sell
Floor => NRV - normal profits
 IFRS: Market is the NRV.
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63
Inventory Valuation - Example
 Selling price = 12
 Package cost = $1
 Transportation cost = $3
 Normal profits = $3
 NRV = Selling price - Package -
Transportation = $12 - $1- $3 = $8
 NRV - Normal profit = $5
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Inventory Valuation - Example (contd.)
Acquisition Replacement
NRV NRV
Market LCM
Cost
Cost
Profit
$10
a
$10
b
$10
$10
$6
$9
$4
$12
$8
$8
$8
$8
$5
$5
$5
$5
$6
$8
$5
$8
$6
$8
$5
$8
a. Example of the ceiling can prevent future
unexpected loss.
b.Example of preventing the recognition of
abnormal loss in the current period.
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65
Inventory Valuation - LCM



For financial reporting, LCM can be
performed at the individual item level, at the
category level or at the total inventory level.
Common practice: at the individual item
level.
LCM performed at the individual item level is
most conservative and is most commonly
used because it is complied with the IRS
rule.
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66
LCM Application - at Individual Level
versus at Group Level
Item
A
B*
C
Total
Cost
$50
$140
$300
$490
_____
_____
Market LCM (at individual level)
$60
$50
$100
$100
$360
$300
$520
$450
_____
_____
_____
_____
LCM at group level ==> $490
The difference of $40 is resulting from item
B: $140 - 100 = $40
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67
LCM and iGAAP




IAS No. 2 requires inventory to be valued
at LCM which can be applied at different
levels of inventory as in GAAP.
The market value of IAS is the NRV, not
the replacement cost as in US GAAP.
IAS allows the reversal of inventory writedown when the conditions for write-down
do not exist.
US GAAP does not allow the reversal of
inventory write-down.
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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
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69
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.
Inventories: Measurement
70
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.
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71
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):
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72
Journal Entry to Restate the
Beginning Inventory to Cost (contd.)

Alternative 1:
Allowance to Reduce
Inventory to Market
10,000
Adjustment to Record
Inventory at cost
10,000
(If an allowance method is used in LCM
application.)
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73
Journal Entry to Restate the
Beginning Inventory to Cost (contd.)

Alternative 2:
Inventory
10,000
Adjustment to
Record Inv. at Cost
10,000
(only If a direct write-off method is used in
LCM application)
Inventories: Measurement
74
Footnote Disclosure of Changing
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
75
8. LIFO Inventory Pools (Specific Goods
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.
Inventories: Measurement
76
LIFO Inventory Pools (contd.)*



LIFO inventory pools technique can:
1) simplify recordkeeping by grouping
inventory into pools, and
2)reduce the probability of LIFO layer
liquidation/erosion.
Inventories: Measurement
77
LIFO Inventory Pools (contd.)


Within pools, all purchases of goods in the
pool are considered to be made at the
same time during the period and at the
average cost.
When the quantity of ending inventory in
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
78
LIFO Inventory Pools: An Example
(contd.) (skip 78-81)

The 2008 beg. inventory (BI)of Cole Glass Inc.
LIFO inventory pool consisted of the following:
Quantity (squared
foot (SF))
Cost (per
SF)
Total Cost
Grade A Window 10,000
Glass
$3.00
$30,000
Grade B
14,000
$2.50
$35,000
Grade C
11,000
$2.20
$24,200
Totals
35,000
Average SF Cost $2.55 =
of the Pool -BI
$89,200
($89,200/
35,000)
Inventories: Measurement
79
LIFO Inventory Pools: An Example

During 20x8, Cole sold 48,000 squared feet of
window glass and purchased 51,000 squared
feet as follows:
Quantity (squared
foot (SF))
Cost (per SF)
Total Cost
Grade A Window
Glass
20,000
$3.10
$62,000
Grade B
15,000
$2.60
$39,000
Grade C
16,000
$2.45
$39,200
Totals
51,000
Average 2008 SF
Cost of the Pool
$2.75 =
$140,200
($140,200/
51,000)
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
81
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
Inventories: Measurement
82
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.
Inventories: Measurement
83
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
85
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).
Inventories: Measurement
86
The Cost Index


When the price level of the EI differs from
that of BI, a cost index should be used to
adjust the DV of EI at the price level of the
BI before forming the layers for the EI.
Cost index of a layer year =
Cost in layer year/Cost in base year
 Base year is the year in which DV LIFO is
adopted and a layer year is any
subsequent year in which an inv. Layer is
Inventories: Measurement
87
Dollar Value LIFO – An Example
Layer Current Cost Cost
Year
20x0 a
20x1
20x2
20x3
EI at
of Ending (Price) Base year
Inventory Index Price Levl.
$20,000
100
$20,000
$30,000
120
$25,000
$35,100
130
$27,000
$40,600
140
$29,000
Value of
Inv. At
D-V LIFO
$20,000
$26,000
$28,600
$31,400
a. the base year
Inventories: Measurement
88
Example (contd.)
Forming of layers:
20x0
20x1
20x2
20x3
20,000 ... L1 20,000...L1 20,000...L1 20,000...L1
5,000...L2 5,000...L2 5,000...L2
2,000...L3 2,000...L3
2,000 ..L4
Converting to the corresponding year’s index level:
20x0
20x1
20x2
20x3
20,000x1
=20,000
20, 000x1+ 20,000x1+ 20,000x1+
5 ,000x1.2 5,000x1.2+ 5,000x1.2+
=26,000 2,000x1.3 2,000x1.3+
=28.600 2,000x1.489
Inventories: Measurement
Comments on Dollar-Value LIFO


Items with similar economic, not
physical, characteristics (i.e., subject to
similar cost change pressure) will be
pooled together.
The more items are included in an
inventory pool, the less likely the
erosion of the LIFO layers can occur.
Inventories: Measurement
90
Comments on Dollar-Value LIFO
(contd.)*


Income number can be manipulated by
changing the number of inventory
pools.
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
An Example of Manipulating Income by
Changing the Number of Inventory Pools

Stauffer Chemical Company had
increased LIFO pools from 8 to 280 ,
boosting its net income by $16,515,000
(13%) (source: KWW, 14th edition, p461).
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
93
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.
Inventories: Measurement
94
The Internal Indexes
A Double-Extension Method (i.e., the value
of inv. units extended at both current and base-year
prices):
Internal Index for the Current Year =
End. Inv*. at Current Year’s Cost
End. Inv. at Base-Year Cost
End. Inv. is the ending inventory of the
current year.
The cost index for the base year equals one.
Inventories: Measurement
95
Example

To compute specific internal price indexes:
Year
20x0 (base year)
20x1
20x2
20x3
Current Units of
Cost End. Inv.
$19
300
$22.8
400
$24.7
450
$26.6
370
Cost
Index(%)
100a
120b
130c
140d
a. 19*300/19.0*300=100% c.24.7*450/19*450=130%
b. 22.8*400/19*400=120% d.26.6*370/19*370=140%
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