5. Inventory Costing Methods, Special Issues Related to LIFO

What are the 4 inventory costing methods?

1. Specific Identification

2. FIFO

3. LIFO

4. Average Cost

What is the LIFO Reserve?

The difference between the inventory method used for internal reporting purposes and LIFO is called the LIFO Reserve (aka LIFO Allowance, Allowance for LIFO Reserve, or Allowance to Reduce Inventory to LIFO) which is a contra account to Inventory.

What is the LIFO effect?

The change in the LIFO reserve balance from one period to the next is called the LIFO effect.  This is the adjustment that must be made to the accounting records in a given year.

Entry to record LIFO effect (assuming increase in LIFO reserve)

Debit COGS for LIFO effect, Credit LIFO Reserve for LIFO effect.

Does LIFO reserve has a normal debit or credit balance?

Credit.

Entry to record increase in LIFO reserve

Debit COGS for difference between balance in the reserve at end of the year and beginning balance, Credit LIFO Reserve for same amount.

Entry to record decrease in LIFO reserve

Debit LIFO Reserve for difference between balance in the reserve at the end of the year and beginning balance, Credit COGS.

What is LIFO liquidation?

LIFO liquidation is when you sell a lot and eat up all of your recent inventory layers to the point that you dip into layers of low inventory cost from long ago.

LIFO Liquidation results in the distortion of net income and substantial tax payments.

What happens with LIFO pools?

Under LIFO inventory pools inventory items similar in nature can be combined into pools based on physical similarities. This allows a company to account for a few inventory pools rather than every specific type of inventory separately.

What is the benefit of LIFO pools?

LIFO liquidations are less likely to happen with this approach because the reduction of one quantity in the pool may be offset by an increase in another.

What is the most commonly used LIFO approach in the real world?

The dollar-value LIFO approach.

What is used to convert the inventory value from LIFO to dollar-value LIFO?

The cost index.

What is the formula to calculate cost index in a layer year for dollar value LIFO?

Cost in Layer year / Cost in Base year

The base year is the year in which the dollar-value LIFO method is initially adopted and is set at 1.00.

The layer year is any subsequent year in which an inventory layer is created.

What is the first step for Dollar-Value LIFO Inventory Estimation?

Convert ending inventory valued at year-end cost to base year cost by dividing the ending inventory by the year's cost index to get an amount that can be compared directly with beginning inventory. This way we can see if there was a real increase in inventory rather than an illusory one caused by price increases.

What formula is used in step 1 for Dollar-Value LIFO Inventory Estimation?

Ending inventory at base year cost (step 1, Dollar Value LIFO) = Ending Inventory at year-end cost / Cost Index (either calculate or given in problem)

What is step 2 for Dollar-Value LIFO Inventory Estimation?

Identify the layers of ending inventory and the years they were created.

What formula is used in step 2 for Dollar Value LIFO Inventory Estimation?

Increase in base year dollars (step 2, Dollar Value LIFO): Ending inventory at base year cost (from step 1, this means beginning of the year prices) - beginning inventory value.

• This increase represents a real increase in inventory quantity during the year.

If it is determined that inventory quantity had decreased during the year, then no new layer would be added. The most recently added layer would be decreased to the inventory valuation determined in step 1. Once a layer of inventory or a portion of a layer is used (meaning it is sold) it cannot be replaced. Future increases in inventory quantity will result in new layers being added.

What is step 3 for Dollar-Value LIFO Inventory Estimation?

Convert each layer's base year cost to the layer year cost using the cost index for the year it was acquired.

What formula is used in step 3 for Dollar Value LIFO Inventory estimation?

Formula to convert each layer's base year cost to layer year cost (step 3, Dollar Value LIFO) = Increase or decrease in ending inventory at base year cost x cost index.