LIFO Inventory Valuation Analysis 1

Introduction: The convergence from U.S. GAAP (Generally Accepted Accounting Principles) to conforming to the IFRS (International Financial Reporting Standards) faces numerous hurdles and obstacles. One of which is the various methods used to value inventories under U.S. GAAP. Currently, U.S. GAAP allows the use of three primary inventory evaluation methods: Last-in, First-Out (LIFO), First-in, First-out (FIFO), and the weighted average method. Both U.S. GAAP and IFRS are similar in that they both require the use of balance sheets, income statements, and notes to financial statements. One of the most controversial and problematic issues about U.S. complying with the IFRS stems from the use of the many methods used to account for inventory, to include the use of the LIFO method which ultimately benefits U.S. companies on the tax level. History of Accounting for Inventories: Globalization drives the need for countries and companies to create standards in accounting that will provides a means for stakeholders to analyze financial statements by ensuring that all financial statements are consistent, comparable and understandable. The initial purpose for reporting inventories on financial statements in the United States allowed companies to account for property taxes, which provided a substantial amount of revenue for the government (Lessard, 2007). The focal point has shifted towards focusing on how companies account for inventories and the overall effect it has on pre-tax net income. This change in focus is attributed to the acceptance of the FIFO and weighted average methods that became popularized in 1918, when
Comment [M1]: Instead of saying the use of many methods, maybe you can allude to what those methods are here. Also, the second half of this sentence sounds like a run-on sentence. Maybe try to break it down into two sentences or reword it to make it sound smoother.

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Congress approved these methods as a means of accounting for inventories to reflect income (Lessard, 2007). The First-in, First-out (FIFO) is an inventory valuation method which assumes that the first product or item placed into inventory will in turn be the first item used or sold. FIFO assumes that the costs related to the goods first-in are directly correlated to the costs of goods that are first sold. The FIFO cost-flow assumption allows companies to correlate the costs associated to the first-in goods and first goods sold, but it does not control the physical flow of goods. Some companies opted to use the weighted average method, which allows companies to price their inventory based on an average cost of all goods obtained in that period. This method provides for a more simplistic way of accounting for costs associated with inventory. Another commonly used method in the early 1900s was the use of base-stock method, which would set the stage for the creation of the Last-in, First-out (LIFO) method. The ideal behind the use of the base-stock method allowed allows companies, which were required to maintain a level of inventory in order to do business on a day-today basis, an opportunity to account for these inventories. The goal of the base-stock method was to treat the required level of inventory as a fixed asset and valued it at its original cost (Romeo, 2008). If the fixed level of inventory ever sunk below the required amount, also known as the reserved amount, then the company would be allowed to write down new inventory to replenish the required amount at its original cost basis. In essence, the base-stock method allowed for companies to maintain a level of required inventory and encouraged companies to use the most recent inventories first and record them at their current cost. LIFO incorporates the base-stock method principles, while

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expanding it to create a more definitive depiction of accounting for inventories, which as it is used today. Comparison of FIFO and LIFO: In FIFO, companies draw on and use goods in the order in which they have been purchased. For example, if a manufacturing company had previously purchased materials for their production of plastic storage units, the company would use those previously purchased materials first and the costs associated with those materials would be recorded as the cost of goods sold. This method also applies to merchandising companies, in which the first goods purchased, from a manufacturer, will be the first goods sold. The remaining inventory for the period would then represent the most recent purchases of the company. This allows companies to record the cost associated with the removed product at its initial cost incurred, not the current costs associated with the inventory. The FIFO method ultimately draws on many benefits for companies who choose to participate in the use of this method. One major benefit associated with this method is that the ending inventory recorded closely mirrors the current costs of the inventory. This allows for a more accurate depiction of the costs associated with the remaining inventory. The FIFO method also prevents the opportunities of companies that use this method from manipulating their income, because the FIFO method captures the current costs associated with the inventory. This leads to the disadvantage of FIFO, the fact that using the FIFO method does not accurately match current costs with current

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revenues on the income statement, because the company charges the oldest costs against the most recent revenues, causing a distorting effect on the net income. The LIFO method provides those companies who must maintain a required level of inventories an optional way to record their costs and revenues linked to the inventory. The LIFO method assumes that the costs of the most recently purchased goods are expensed as part of to cost of goods sold for the period. As a result, older costs remain in inventory on the balance sheet (Mulford & Comiskey, December). The concept behind companies utilizing the LIFO method is that it ensures those goods that are sold or used during a given time period are those the most recently purchased, but this distorts the true value of inventories recorded on the balance sheet because the older inventory costs will be remain. LIFO firms include the cost of the most recently purchased items in cost of goods sold; the older and lower costs remain and are the basis for the valuation of the ending inventory (Mulford & Comiskey, December). Companies who use the LIFO method also use the FIFO method for internal purposes. Since the LIFO method will report a lower cost of goods sold, this will create a difference in reported inventories, called LIFO reserves. The Securities Exchange Commission (SEC) requires companies who use two different methods to make an adjusting entry to depict this difference (LIFO Reserve: (An Issue Related to LIFO Inventory Valuation Method):, 2011). For example, if a corporation uses the FIFO method for internal reporting purposes, and uses the LIFO method for external reporting purposes. and had aThe corporation has a beginning balance of $100,000 in allowance to reduce inventory to LIFO and the ending balance should be $40,000., Therefore, the

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following adjusting entry must be made: the Rodger Corporation must make the following adjusting entry: Cost of Goods Sold Allowance to reduce Inventory to LIFO $60,000 $60,000

This entry, known as the LIFO effect, records the adjustment that companies must make to the accounting records in a given year (Kieso, Weygandt, & Warfield, 2012). The changes in the LIFO reserves arise from a direct relationship between the prices of the goods and the cost of the inventory reserve. So as prices increase, the LIFO reserve will normally increase as well, because older and lower costs in the LIFO inventory are increasingly less than replacement cost (Mulford & Comiskey, December). This conceptual understanding also applies when the prices decrease,and the LIFO reserve will ultimately decreases. The change in LIFO reserves may also be attributed to the changes in inventories or the changes in inventory costs, or both. LIFO Layers: A Closer Look The following example illustrates how LIFO reserves work, while also explaining what eating into LIFO layer really means. To illustrate, assume a company began operating in 2010 and used the LIFO method for valuing their inventory. If the company recorded ending inventory at December 31, 2009 of 20 units at a cost of $100 or total inventory costs of $2,000. The $2,000 represents the companys base layer or the first layer. In 2010, the company purchased 40 units at $105 each and sold 35 of those units. The 5 units unsold for 2011 would represent the second LIFO layer at a cost of $525 and the total inventory to be recorded for 2011 would be $2,525 ($2,000+ $525).

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Now assume that the company purchased 40 more units and sold 44 units in 2012 at a price of $120. The company would account for the first 40 units sold at $120 ($4,800) and the additional 4 units would be recorded at $105 ($420) or the most recent LIFO layer. The inventory to be recorded at the end of 2012 would be $2,105, the base layer of $2,000 (20 units at $100) plus the second layer of $105 (1 unit at $105) (Lessard, 2007). LIFO layers provide companies with several strategic methods of tax avoidance, but can also lead to some major issues. A company who intentionally eats into their LIFO layers may do so in order to increase net income and profits. Although this would lead to increased taxes, the company may do this to meet Wall-Streets expectations that otherwise would be unattainable. The downside to involuntarily eating away at LIFO reserves is that it causes distortion of net income, causing the company to pay larger amounts in taxes that where once avoided. Companies may also avoid eating into LIFO layers by purposely purchasing or manufacturing excess goods at the end of the year, which leads to poor buying habits. The Dollar-Value LIFO Method: Companies who partake in using LIFO and LIFO layers have the option between traditional LIFO and the more commonly accepted dollar-value LIFO. To better understand why many companies prefer to use the dollar-value LIFO method, it is important to understand that the method uses pools, or a group of items that are similar in nature. The dollar-value LIFO method determines and measures any increases or decrease in a pool in terms of total dollar value, not the physical quantity of the goods in
Comment [M2]: You mentioned understand twice in this sentence. You could use another word such as know or recognize.

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the inventory pool (Kieso, Weygandt, & Warfield, 2012). Companies with a number of products will often times use this method to help protect LIFO layers. Dollar-value LIFO also pleases the SEC because it forces companies to generate numerous pools, making it more difficult to manage, therefore reducing the manipulation of income by spreading out costs associated with each specific inventorial item. Although this method helps alleviate some issues linked to traditional LIFO, the dollar-value LIFO is subjective in that it is left to companies to decide exactly which products correlate with what pool (Kieso, Weygandt, & Warfield, 2012). The Advantages of Using the LIFO Method: The LIFO method provides its users with some very strategic advantages that make it appealing to various companies. The most palpable benefit of using the LIFO method as opposed to the FIFO method is that it is consistent with matching principal. The LIFO method allows for the more recent costs to correspond with the more recent revenues. This matching of expenses with revenues ultimately prevents companies who use LIFO from creating paper profits or better known as inventory profits, which occurs when companies use other inventory methods. These inventory profits incur when inventory costs matched against sales are less than the inventory replacement costs, ultimately causing an understated amount to be recorded as cost of goods sold and overstating profits (Kieso, Weygandt, & Warfield, 2012). Using LIFO allows companies to reduce the amount of inventories that would be reported, which in turns gives a more accurate depiction of inventories on the balance sheet.

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The tax benefit associated with the use of the LIFO method to valuate inventories provides a great deal of tax relief for companies that are required to maintain a certain level of inventories in order for the company to operate. The reasoning behind the tax benefit returns to the principle of matching. When a company records the LIFO, the costs associated to the most recent purchases are priced at the high end and then matched to the associated revenues. This means that the company using the LIFO method will in turn report lower profits, which in turn allows allowing a company to pay less in taxes. The only stipulation to using LIFO for obtaining such lucrative tax benefits is that a company who uses LIFO for taxes must also use the LIFO method for its financial accounting in order to abide by the LIFO conformity rule (Kieso, Weygandt, & Warfield, 2012). To illustrate this, suppose you are a manufacturing company and you purchase a widget for $20, but and you mange to sell it for $40 in the near future. Several months later the price of the widget increases to $25. Under the LIFO method, you would write of the cost of goods sold at the most recent cost of $25. This differs from the FIFO method because under the FIFO method you would write of the cost of goods sold at the initial cost of $20. So the profit that would be recognized under the LIFO method would be $15 per widget sold and under the FIFO method a $20 profit. This demonstrates that the company using the LIFO method would report a lower profit, thus paying less in taxes. The LIFO method also provides users the opportunity to hedge future earnings, which means that the company can minimize write-downs to market. The minimizing of write-downs occurs because a company records the most recent inventory as sold first,

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which in turn allows for reduced vulnerability to price declines (Kieso, Weygandt, & Warfield, 2012). So by recording inventory using the LIFO method at current dollars, they are less likely to have an adjustment to lower of cost or market. Disadvantages of Using the LIFO Method: Along with the several advantages, LIFO also faces several drawbacks that may force some companies away from using this method for inventory valuation. One of the most obvious drawbacks is the reduced earnings. As stated abovealready stated, companies who use LIFO benefit from recording lower profits, but it may also confuses current and potential investors. An investor may notice that a company is recording lower than normal profits, but may not understand the concept behind using the LIFO method to obtain the lower profits. Investors look for companies that record higher profits and are less concerned about the lower taxes that the company will pay. So the lower profits may scare investors away, making it more difficult to obtain financing from investors. Another problematic issue related to using LIFO stems from the fact that it will creates a distorting effect on the balance sheet. This happens simply because the inventory that remains on the balance sheet represents the inventories oldest costs. The major issue with understating the inventory is that it makes the company appear worse than it really is because of the rising product prices and avoidance of inventory liquidation. The difference between the current price of inventory and the actual carrying amount of the product using LIFO is what creates the distorting effect (Kieso,

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Weygandt, & Warfield, 2012). Unfortunately, this distorting effect leads to additional problems including an involuntary liquidation of inventory and poor buying habits. The involuntary liquidation arises when there is a reduction in inventory below the required amount, causing the company to eat away at their LIFO reserves. Since the LIFO inventory is normally carried at costs below current replacement costs, cost of goods sold is reduced by the inclusion of the lower costs associated with the liquidated inventory (Mulford & Comiskey, December). Due to the lower costs used for the liquidated inventory it will result in an increase in profitsprofit increases for the company on the income statement for the year. A company who uses LIFO may intentionally do this to create additional profits, which will allow the company to attain certain targets set forth by the company. This LIFO liquidation is an acceptable tool that companies may use, so long as they company properly discloses this information in their notes to their financial statements. The example listed below provides readers with a visual understanding of the affectseffects of LIFO reserves on earnings: Exhibit 1: Earnings and LIFO Liquidations Data: Opening inventory, 2 units at a cost of $5.00 each $10.00 Purchases: NO LIFO Liquidation case: 10 units @ a cost of $20.00 each $200.00 YES LIFO Liquidation case: 9 units @ a cost of $20.00 $180.00 Sales: 10 units @ $35.00 each $350.00 LIFO Liquidation NO Sales $350.00 Cost of goods sold computation: $350.00 YES

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Beginning inventory $ 10.00 Purchases 180.00 Cost of goods available for sale 190.00 Less ending inventories: No liquidation: 2 units @ $5.00 Liquidation: 1 unit @ $5.00 Cost of goods sold 185.00 Gross profit $165.00

$ 10.00 200.00 210.00

10.00 5.00 200.00 $150.00

http://smartech.gatech.edu/bitstream/handle/1853/26316/fal_ga_tech_cf_lifo_2008.pdf?sequence=1

Although the primary purpose for LIFO liquidations is to generate short-term profits and net income, the overall effect of this is often times disadvantageous to companies because it distorts net income, leading to considerable tax payments. U.S. GAAP and IFRS Face-Off: The issue of U.S. GAAP transitioning to IFRS has been faced with some major problematic issues. In order for U.S. companies to comply with IFRS, the elimination of LIFO for valuating inventories remains a key focal point of the debate. On November 21, 2008, the Securities and Exchange Commission (SEC) published a roadmap towards mandatory compliance of IFRS by U.S. companies by the year 2014, which entails that current users of LIFO will have to explore other options of valuating their inventories (Hoffman & McKenzie, 2009). The SECs decision to conform to IFRS stems from two main factors: the need for more conformity and comparability amongst financial statements for investors and a means of generating tax revenue for the U.S. The transition will encourage LIFO users to adopt the IFRS accounting methods, which

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entails paying taxes on substantial amounts of inventory reserves that were deferred, over a specified number of years. The need for convergence to IFRS will hold LIFO companies accountable for paying taxes on amounts that were once avoided by creating LIFO reserves. One study revealed the tax effect associated with changing from U.S. GAAP, primarily the use of LIFO for valuating inventories, to IFRS was material with respects to the amount saved on paying taxes. It revealed that 36% of US companies use LIFO in valuing all or a portion of their inventories (White, 2009). Furthermore, the study reviewed a sample of 30 companies with the largest percentage of LIFO reserves to total assets, and found that their pretax income would be higher on average by 10% and 12% in 2006 and 2007, respectively, if they used FIFO in valuing their inventories (White, 2009). The study was conducted using the 30 largest companies, based on level of LIFO reserves that would be materially affected by the shift to IFRS. The study also mentioned that the change in pre-tax income and taxes due on inventory reserves, due to the change from LIFO to FIFO, would amount to about $15 billion (White, 2009). Exxon Mobile Corporation is a world-wide company that primary business is in the excavation of oil and generates a substantial amount of LIFO reserves. To better understand the need to transition from U.S. GAAP to IFRS, Exxon Mobil provides some insight to the how creative some companies get to avoid paying taxes. Exxon Mobil Corporation had a LIFO reserve balance of $25.4 billion at the end of its fiscal year 2007. At a 35% effective tax rate, the company would be forced to pay the IRS approximately US$2.2 billion a year for four years (approximately US$8.9 billion in total, or 4% of its total assets) (White, 2009). Exxon Mobil, like many other large
Comment [M3]: The wording here is slightly confusing to me.

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corporations, have managed to find a lucrative means of generating wealth for the company by eluding taxes on inventory layers. The matter is not if, but when will the transition from following U.S. GAAP to IFRS will happen. The SEC needs to be willing to work with those companies currently using LIFO by creating some procedures that will better ensure the companys survival after the transition. One solution to relieve opposition to the conversion would be to do away with the conformity rule; this would allow companies to continue using LIFO for taxreporting purposes, and use FIFO or weighted average cost for IFRS (White, 2009). Although this defeats part of the reason for the change by the SEC, it may eventually lead to complete convergence by all companies. Another possible incentive to guide LIFO companies in the right direction may be to extend the payback period for the taxes. Perhaps, by spreading the tax payments over four years, they could rather be spread over 10 years, which may make the shift achievable for LIFO corporations. Though these solutions are just a few of many potential opportunities to encourage change, the SEC must be willing and able to work with companies, in order to achieve the convergence. Conclusion: Since the enactment of the Revenue Act of 1939, authorizing the use of LIFO for every taxpayer and discarded the undistributed profits tax, companies have reaped major tax benefits (Romeo, 2008). The use of the LIFO method as a means of valuating inventories has come under heavy fire from oppositionists and for good reason. For companies to intentionally avoid taxes on inventories as a means of
Comment [M4]: This word could also be instead.

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generating wealth for the company goes against the U.S. tax principles. The convergence from U.S. GAAP will be disadvantageous for those companies who currently use LIFO, but in the long run, it will provide for greater comparability and conformity on the international level for all users of financial statements.