Appendix 6-A

LIFO MEASUREMENT ISSUES

This appendix is concerned with two measurement issues that arise when the LIFO method is used:
Different varieties of LIFO Difculties when LIFO is applied to interim earnings

Although these issues arise frequently, they are segregated within this appendix to simplify the presentation in the chapter itself.

LIFO INVENTORY METHODS

The discussions in the chapter implicitly assume that:
Firms account for each inventory item There is only one manner of applying the LIFO method of accounting

Neither assumption is correct. In practice, all but the smallest rms have far too many inventory items to use specic item-based costing methods efciently. The potential for LIFO liquidations and the resulting loss of tax benets are additional deterrents to the use of specic item methods. More efcient methods of applying LIFO to inventories involve the pooling of substantially identical inventory units to compute unit costs and physical quantities. Reeve and Stanga (1987) found that a majority of LIFO method companies use a single pool, generally dened by the natural business unit, and they use the same pooling method for nancial reporting and taxes although conformity is not required. The number of pools used was inversely related to the magnitude of tax benets (companies with large tax savings from LIFO tended to use fewer pools). They also reported substantial variation in the number of pools used within an industry and across all the rms in their sample. The impact on cash ows and nancial statements suggests that analysts should carefully evaluate announcements of changes in LIFO pools to understand the impact of the change on reported earnings. Example: Oxford Oxford [OXM], a clothing manufacturer, uses the LIFO method for most inventories. In scal 2002, Oxford reduced the number of inventory pools used to compute LIFO from ve to three. As a result, the company avoided a LIFO liquidation that would have increased net income by 30% (and would have resulted in signicant tax payments).1 The company stated that one reason for the change was to reduce the likelihood of LIFO layer liquidations. The change was reported as a change in accounting principle. Inventories may also be pooled on the basis of similarity of use, production method, or raw materials used. Liquidations are reduced because these dollar value LIFO methods compute inventories using dollars, facilitating substitutions of items in the pools. Inventory
1

Despite the change in number of pools, Oxford reported a small LIFO liquidation for the year.

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APPENDIX 6-A

LIFO MEASUREMENT ISSUES

layers may be priced using indices published by the Bureau of Labor Statistics or internally developed indices. The differences can be substantial. For example, during 1990 Kmart switched to internally generated indices (from the U.S. Department of Labors Department Store Price Index) for its U.S. merchandise inventories. The nancial statement footnote stated the rms belief that the internal index results in a more accurate measurement of the impact of ination on the prices of merchandise sold in its stores. The change reduced its COGS by $105 million (net of tax), increasing income by $0.52 per share (32.3% of reported income for the year). Retailers use more complex LIFO methods. Interested readers are referred to intermediate and advanced accounting texts for explanations of the LIFO Retail and Dollar Value LIFO Retail methods.

INTERIM REPORTING UNDER LIFO

As discussed in Chapter 1, interim reporting creates special problems for both nancial reporting and nancial analysis. Because LIFO is a tax-based inventory method, its use creates additional problems. The actual LIFO effect for the year cannot be known until the year is complete. Thus, LIFO charges for interim periods require management assumptions regarding both inventory quantities and prices at the end of the year. Technological changes, uctuations in demand, and strikes may also result in a reduction in LIFO layers during the year. The application of LIFO during interim periods may result in substantial distortions (income statement and balance sheet) if the factors causing the LIFO liquidations are temporary and the layers will be replenished prior to year-end. Financial reporting for interim periods is governed by APB Opinion 28, which provides special inventory valuation procedures during interim periods when the rm experiences a LIFO liquidation during one or more of the rst three quarters. Permanent liquidations must be reported in the quarter of occurrence. However, when management believes that the liquidated layer(s) will be replenished before year-end, the cost of goods sold for the quarter must include the estimated cost of replacing the temporary liquidation rather than the LIFO cost of the goods sold. The application of this method is illustrated using the following example: Assumptions: All transactions occur during the second quarter Beginning inventory (FIFO): 10 units @ $30 $300 LIFO reserve (@ $20) ($200) LIFO inventory 10 units @ $10 $100 Purchases: 20 units @ $30 $600 Goods available for sale $700 Sales: 21 units @ $40 $840 Management determines that the liquidation is temporary and expects the next purchase price (cost to replace) to be $35. GAAP requires the use of $35 rather than the unit cost of the liquidated layer. COGS is reported at
$635 (20 units @ $30 plus 1 unit @ $35)

Inventory is reduced by
$610 (20 units @ $30 and 1 unit @ $10)

The rm recognizes a current liability (called the LIFO base liquidation) for the difference of $25, indicating that the rm has temporarily borrowed a unit from the base layer.2 The next purchase of inventory is used to eliminate the current liability and replenish the
2

An AICPA issues paper, Identication and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories (AICPA, 1984), suggests that the interim liquidation may also be credited directly to inventories.

INTERIM REPORTING UNDER LIFO

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LIFO base layer. This method eliminates any distortion in reported gross prot and income numbers due to temporary interim period liquidations. Year-end LIFO liquidations are permanent reductions in LIFO layers, and the reported gross prot must include the impact of the reduction in LIFO reserves. If the foregoing scenario occurs during the fourth quarter, the rm would report COGS of $610 [(20 $30) (1 $10)] and separately disclose the impact of the LIFO liquidation on COGS and net income in the footnotes. Example: Nucor The following example illustrates the impact of volatile prices and the procedures required for interim reporting. It is based on Nucor Corp., a steel and steel products manufacturer that uses the LIFO method of inventory accounting. Steel scrap is a major component of inventory cost, and since scrap prices can be volatile, Nucor must estimate its year-end position at the end of each interim period. That is, it must estimate both physical inventory and the price of scrap at year-end to establish the appropriate LIFO reserve at the end of each interim period. In 1981, scrap prices rose during the rst part of the year, but declined in the second half. The LIFO reserve declined for 1981 as a whole, reecting a decline in the price of steel scrap. (At the end of 1981, the difference between the LIFO and FIFO cost of its inventory was lower than it had been one year earlier.) During the rst two quarters, Nucor assumed that scrap prices would be higher at the end of 1981 than one year earlier and accrued additional LIFO reserves. Because of the decline in steel scrap prices late in the year, these earlier accruals were reversed in the fourth quarter. The impact of the interim changes in the LIFO reserve can be seen in the following table: Reported Nucor Quarterly Results 1981 ($ in thousands) Quarter Pretax income LIFO effect LIFO reserve (end of period) (12/31/80 $23,727) I $13,087 1,873 $25,600 II $11,204 1,900 $27,500 III $4,637 0 $27,500 IV $15,901 (5,134) $22,366 Year $44,829 (1,361) $22,366

Source: Nucor, 1981 annual and interim reports.

Although the interim LIFO accruals (LIFO effect change in reserve) were made in good faith, in retrospect we can see that they were incorrect and distorted operating results. To correct that distortion, we can (with perfect hindsight) reallocate the decrease in the LIFO reserve for the year so that an equal amount is credited to each interim period. We can obtain the true interim results by restating the LIFO impact as follows: Adjusted Nucor Quarterly Results 1981 ($ in thousands) Quarter Pretax income LIFO adjustment* Adjusted pretax % Change from reported I $13,087 $12,213 $15,300 16.9% II $11,204 $12,240 $13,444 20.0% III $4,637 $4,340 $4,977 7.3% IV $15,901 $ (4,793) $11,108 (30.1)% Year $44,829 $44,820 $44,829 0

*Difference between original LIFO effect and true LIFO effect (one-fourth of annual). For example, the rst quarter adjustment is $1,873 ( $1,361/4).

The Nucor case indicates that management assumptions can play a major role in reported interim earnings and the application of LIFO accounting to interim periods can result in large distortions in interim comparisons. It should also be noted that there are many ways of making interim LIFO calculations. This illustration also serves as an example of fourthquarter adjustments that have a signicant impact on reported earnings and trends reected during the previous three quarters.