OCW041: Detail on Using LIFO

The LIFO Reserve

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve.

Learning Objectives

Summarize the purpose of a LIFO Reserve

Key Takeaways

Key Points

  • The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.
  • During times of increasing costs, the balance in the LIFO reserve account will have a credit balance, meaning that less cost reported in inventory. Remember, under LIFO the latest (higher) costs are expensed to the cost of goods sold, while the older (lower) costs remain in inventory.
  • The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFO since the time that LIFO was adopted. The change in the balance during the current year represents the current year’s inflation in costs.
  • LIFO reserve = FIFO inventory – LIFO inventory.

Key Terms

  • LIFO: Last-in, first-out (accounting).
  • inventory: A detailed list of all of the items on hand.
  • inflation: An increase in the quantity of money, leading to a devaluation of existing money.

The LIFO Reserve

Last-In First-Out (LIFO) is the opposite of First-In First-Out (FIFO). Some systems permit determining the costs of goods at the time acquired or made, but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. Such a reserve (an asset or a contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions.

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Seasonal Inventory: Valuing inventory using the LIFO method.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

LIFO Reserve in Action

Suppose a company uses FIFO for its internal accounting system, but wants to use LIFO for financial and income tax reporting (due to continuous inflation of its costs). In this instance, the LIFO reserve is a contra inventory account that will reflect the difference between the FIFO cost and LIFO cost of its inventory.

During times of increasing costs, the balance in the LIFO reserve account will have a credit balance, meaning that less cost is reported in inventory. Remember, under LIFO the latest (higher) costs are expensed to the cost of goods sold, while the older (lower) costs remain in inventory.

The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFO since the time that LIFO was adopted. The change in the balance during the current year represents the current year’s inflation in costs.

Benefits

  • The change in the balance in the LIFO reserve will also increase the current year’s cost of goods sold. This in turn reduces the company’s profits and therefore, taxable income.
  • The change in the balance of the LIFO reserve during the current year times the income tax rate results in the difference in the income tax for the year. Changing this formula slightly, one can find the difference in income tax since LIFO was adopted (the balance in the LIFO reserve times the income tax rate).
  • The disclosure of the LIFO reserve is better for comparing the profits and ratios of a company using LIFO with the profits and ratios of a company using FIFO.

Additional Information

The accounting profession has discouraged the use of the word reserve in financial reporting, so LIFO reserve may sometimes be called: Revaluation to LIFO, Excess of FIFO over LIFO cost, or LIFO allowance.

LIFO reserve = FIFO inventory – LIFO inventory

FIFO inventory = LIFO inventory + LIFO reserve

Comparability

If a company uses LIFO, the recorded amount of inventory is not an accurate reflection of cost, reducing comparability to companies using FIFO.

Learning Objectives

Explain why comparability is important for valuing a company

Key Takeaways

Key Points

  • The LIFO method results in lower ending (and beginning) inventory on a company’s balance sheet because the oldest (and therefore usually less expensive due to inflation) items remain in the inventory.
  • If a company uses LIFO, recorded inventory is not an accurate reflection of cost of the current period. This low valuation affects the computation and evaluation of current assets and any financial ratios that include inventory, reducing comparability between companies using different methods.
  • The most common normalization adjustments fall into the following four categories: Comparability Adjustments, Non-operating Adjustments, Non-recurring Adjustments, and Discretionary Adjustments.

Key Terms

  • valuation: The process of estimating the market value of a financial asset or liability.
  • adjustment: a small change; a minor correction; a modification
  • comparability: Comparison or equivalence.

Why Comparability is Important

Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to perfect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to:

  • estate and gift taxation,
  • divorce litigation,
  • allocating business purchase price among business assets,
  • establishing a formula for estimating the value of partners’ ownership interest for buy-sell agreements,
  • and many other business and legal purposes.

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Seasonal Inventory: Valuing inventory using the LIFO method.

Inventory Valuation with LIFO

The LIFO method results in lower ending (and beginning) inventory on a company’s balance sheet because the oldest (and therefore usually less expensive due to inflation) items remain in the inventory. Based off of this information, one can assume that if a company uses LIFO, the recorded amount of inventory is not an accurate reflection of cost of the current period. This low valuation affects the computation and evaluation of current assets and any financial ratios that include inventory, resulting in reduced comparability between companies using LIFO and others using FIFO.

Normalization (adjustment) methods

Comparability Adjustments

The valuer may adjust the subject company’s financial statements to facilitate a comparison between the subject company and other businesses in the same industry or geographic location. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company’s data is presented in its financial statements.

Non-operating Adjustments

It is reasonable to assume that if a business were sold in a hypothetical sales transaction (which is the underlying premise of the fair market value standard), the seller would retain any assets which were not related to the production of earnings or price those non-operating assets separately. For this reason, non-operating assets (such as excess cash) are usually eliminated from the balance sheet.

Non-recurring Adjustments

The subject company’s financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statements will better reflect the management ‘s expectations of future performance.

Discretionary Adjustments

The owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair market value, the owner’s compensation, benefits, perquisites and distributions must be adjusted to industry standards. Similarly, the rent paid by the subject business for the use of property owned by the company’s owners individually may be scrutinized.

Liquidation

In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed.

Learning Objectives

Explain the process of liquidating a company

Key Takeaways

Key Points

  • Liquidation may either be compulsory (sometimes referred to as a creditors ‘ liquidation) or voluntary (sometimes referred to as a shareholders ‘ liquidation, although some voluntary liquidations are controlled by the creditors).
  • After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets.
  • LIFO liquidation refers to when a company using LIFO accounting methods liquidates their older LIFO inventory. This occurs if current sales are higher than current purchases, and consequently inventory not sold in previous periods must be liquidated.
  • Due to inflation, the amount of money companies pay for inventory will usually increase over time. If a company decides to undergo LIFO liquidation, the old costs of inventory will be matched with the current, higher sales prices resulting in a higher tax liability.

Key Terms

  • LIFO: Last-in, first-out (accounting).
  • creditor: A person to whom a debt is owed.
  • liquidation: The selling of the assets of a business as part of the process of dissolving it.

What is Liquidation?

In law, liquidation is the process by which a company (or part of a company) is brought to an end, and the assets and property of the company are redistributed. Liquidation is sometimes referred to as ‘winding-up’ or ‘dissolution’, although dissolution technically refers to the last stage of liquidation. The process of liquidation arises when customs, or an authority or agency in a country responsible for collecting and safeguarding customs duties, determines the final computation, ascertainment of the duties, or drawback accruing on an entry.

Liquidation may either be compulsory (sometimes referred to as a ‘creditors’ liquidation’) or voluntary (sometimes referred to as a ‘shareholders’ liquidation’, although some voluntary liquidations are controlled by the creditors).

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Plane liquidation: Alitalia — Compagnia Aerea Italiana S.p.A. (Italian for Alitalia – Italian Air Company), is an Italian airline, which bought some assets from the liquidation process of the old Alitalia-Linee Aeree Italiane and the entire Air One.

Parties Entitled to Liquidation

The parties who are entitled by law to petition for the compulsory liquidation of a company vary from jurisdiction to jurisdiction, but generally, a petition may be lodged with the court for the compulsory liquidation of a company by:

  • The company itself
  • Any creditor who establishes a prima facie case
  • Contributories
  • The Secretary of State
  • The Official Receiver

Priority of Claims

After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets. Generally, the priority of claims on the company’s assets will be determined in the following order:

  1. Liquidators costs
  2. Creditors with fixed charge over assets
  3. Costs incurred by an administrator
  4. Amounts owing to employees for wages/superannuation (director limit: $2000)
  5. Payments owing in respect of workers’s injuries
  6. Amounts owing to employees for leave (director limit: $1500)
  7. Retrenchment payments owing to employees
  8. Creditors with floating charge over assets
  9. Creditors without security over assets
  10. Shareholders

Grounds for Liquidation

The grounds upon which one can apply for a compulsory liquidation also vary between jurisdictions, but the normal grounds to enable an application to the court for an order to compulsorily wind-up the company are:

  • The company has so resolved
  • The company was incorporated as a corporation, and has not been issued with a trading certificate (or equivalent) within 12 months of registration
  • It is an “old public company” (i.e. one that has not re-registered as a public company or become a private company under more recent companies legislation requiring this)
  • It has not commenced business within the statutorily prescribed time (normally one year) of its incorporation, or has not carried on business for a statutorily prescribed amount of time
  • The number of members has fallen below the minimum prescribed by statute
  • The company is unable to pay its debts as they fall due
  • It is just and equitable to wind up the company

LIFO Liquidation

LIFO liquidation refers to when a company using LIFO accounting methods liquidates their older LIFO inventory. This occurs if current sales are higher than current purchases, and consequently inventory not sold in previous periods must be liquidated.

Due to inflation and general price increases, the amount of money companies pay for inventory will usually increase over time. If a company decides to undergo LIFO liquidation, the old costs of inventory will be matched with the current, higher sales prices. As a result, this cost has a higher tax liability if prices have risen since the LIFO method was adopted.

Dollar-Value LIFO

Dollar value LIFO (last-in, first-out) is calculated with all figures in dollar amounts, rather than inventory units.

Learning Objectives

Summarize the advantages to using dollar-value LIFO inventory valuation

Key Takeaways

Key Points

  • Dollar value LIFO uses this approach with all figures in dollar amounts, rather than inventory units. As a result, companies have a different view of their balance sheets than under other methods (such as FIFO ).
  • If inflation did not affect the statements of companies, dollar-value and non-dollar-value accounting methods would have the same results.
  • However, because inflation does occur and thus, costs change over time, the dollar-value method presents data that show an increased cost of goods sold (COGS) when prices are rising, and a lower net income.
  • This can, in turn, reduce a company’s taxes but make shareholders unhappy due to a lower net income on reports.

Key Terms

  • LIFO: Last-in, first-out (accounting).
  • shareholder: One who owns shares of stock.
  • inflation: An increase in the quantity of money, leading to a devaluation of existing money.

Dollar-value LIFO

This inventory method follows LIFO (last-in, first-out). Dollar value LIFO uses this approach with all figures in dollar amounts, rather than inventory units. As a result, companies have a different view of their balance sheets than under other methods, such as FIFO (first-in, first-out).

If inflation did not affect the statements of companies, dollar-value and non-dollar-value accounting methods would have the same results. However, because it does occur and thus costs change over time, the dollar-value method presents data that show an increased cost of goods sold (COGS) when prices are rising, and a lower net income. This can, in turn, reduce a company’s taxes, but can make shareholders unhappy due to a lower net income on reports.

Dollar-value in the Decision-making Process

Managers apply the concepts of interest, future value, and present value in making business decisions. Therefore, accountants need to understand these concepts to properly record certain business transactions.

The time value of money

The concept of the time value of money stems from the logical reference for a dollar today rather than a dollar at any future date. Most individuals prefer having a dollar today rather than at some future date because:

  1. the risk exists that the future dollar will never be received; and
  2. if the dollar is on hand now, it can be invested, resulting in an increase in total dollars possessed at that future date.

Most business decisions involve a comparison of cash flows in and out of the company. To be useful in decision making, such comparisons must be in dollars of the same point in time. That is, the dollars held now must be accumulated or rolled forward, or future dollars must be discounted or brought back to the present dollar value, before comparisons are valid. Such comparisons involve future value and present value concepts.

Future value

The future value or worth of any investment is the amount to which a sum of money invested today grows during a stated period of time at a specified interest rate. The interest involved may be simple or compound.

Simple interest is interest on principal only. For example, $1000 invested today for two years at 12% simple interest grows to $1240 since interest is $120 per year. The principal of $1,000, plus [latex]2 cdot $120[/latex], is equal to $1240.

Compound interest is interest on principal and on interest of prior periods. For example, $1000 invested for two years at 12% compounded annually grows to $1254.40 as follows:

Principal or present value:

[latex]$1000 cdot 0.12 = $120.00[/latex]

Value at end of year 1:

[latex]$1120 cdot 0.12 = $134.40[/latex]

Value at end of year 2 (future value):

[latex]$1000 + $120 + $134.40 = $1254.40[/latex]

Advantages of LIFO

Using LIFO accounting for inventory, a company generally pays lower taxes in periods of inflation.

Learning Objectives

Describe how using the LIFO method of valuing inventory would benefit a company

Key Takeaways

Key Points

  • LIFO recovers cost from production because actual cost of material is charged to production.
  • Production is charged at the recent prices because materials are issued from the latest consignment. Therefore, the effect of current market prices of materials is reflected in the cost of sales if the materials are recently purchased.
  • In times of rising prices ( inflation ), LIFO is suitable because materials are issued at current market prices (which are high). This method helps in showing a lower profit because of increased charge to production during periods of rising prices and reduces income tax.
  • LIFO is simple to operate and is useful when there are not too many transactions with fairly steady prices.

Key Terms

  • market price: The price at which a product, financial instrument, service or other tradable item can be bought and sold at an open market; the going price.
  • inventory: A detailed list of all of the items on hand.
  • LIFO: Last-in, first-out (accounting).

Accounting Methods

FIFO and LIFO Methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks. These methods are used to manage assumptions of cost flows related to inventory, stock repurchases (if purchased at different prices), and various other accounting purposes.

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Inventory Template: Example of inventory template.

  1. FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold.
  2. LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the U.S.

In Periods of Rising Prices (Inflation)

  • FIFO: (+) Higher value of inventory (-) Lower cost of goods sold
  • LIFO: (-) Lower value of inventory (+) Higher cost of goods sold

In Periods of Falling Prices (Deflation)

  • FIFO: (-) Lower value of inventory (+) Higher cost of goods sold
  • LIFO: (+) Higher value on inventory (-) Lower cost on goods sold

Benefits of LIFO

LIFO considers the last unit arriving in inventory as the first one sold. Which method an accountant selects can have a significant effect on net income and book value and, in turn, on taxation. Using LIFO accounting for inventory, a company generally reports lower net income and lower book value, due to the effects of inflation. This generally results in lower taxation. Due to LIFO’s potential to skew inventory value, UK GAAP and IAS have effectively banned LIFO inventory accounting.

Disadvantages of LIFO

LIFO is facing pressures from international standards boards that may result in its possible complete elimination.

Learning Objectives

Summarize the disadvantages of using LIFO

Key Takeaways

Key Points

  • LIFO is facing pressures from international standards boards that may result in its possible complete elimination.
  • Most of the developed countries, such as Australia, New Zealand, Canada and the European Community Union, have adapted IFRS by the year 2011.Under IFRS rules, LIFO is not a permitted acceptable accounting method.
  • The use of LIFO disrupts the theoretical foundation of the IFRS and if plans proceed as expected, complete phase-out of LIFO will occur in the near future.

Key Terms

  • LIFO: Last-in, first-out (accounting).

LIFO is facing pressures from both the International Reporting Standards Board in cooperation with the SEC and the U.S. Congress for its possible complete elimination. On November 15, 2007, the Securities and Exchange Commission (SEC) exempted foreign firms from including reconciliation from International Financial Reporting Standards (IFRS) to U.S. Generally Accepted Accounting Principles (U.S. GAAP) when filing on U.S. Stock exchanges. Foreign public firms are now permitted to file using the International Financial Reporting Standards (IFRS) without reconciliation to U.S. GAAP as previously required. This move has created a mandate to converge IFRS and U.S. GAAP and financial statement requirements (SEC, 2007).

Inventory: Inventory in a warehouse.

On June, 18, 2008, the SEC issued a press release stating that the world’s securities regulators are uniting to increase their oversight of international accounting standards. Most of the developed countries, such as Australia, New Zealand, Canada and the European Community Union, have adapted IFRS by the year 2011.Under IFRS rules, LIFO is not a permitted acceptable accounting method. IFRS is balance sheet oriented and, on this basis, disallows LIFO as an inventory method. The use of LIFO disrupts the theoretical foundation of the IFRS and if plans proceed as expected, complete phase-out of LIFO will occur in the near future. More importantly is the current tax position on LIFO. In prior budgets, the Obama Administration has proposed to repeal LIFO altogether in an attempt to generate greater tax revenues.


Source: Accounting