Inventories and CGS

RCJ Chapter 9
Key Issues
1. Effect of LIFO on financial statements
2. LIFO layers
3. LIFO reserve
4. Change in LIFO reserve
5. Price vs. quantity effects
6. LIFO and earnings management
7. LIFO footnote
8. LIFO tax savings
9. LIFO FIFO switch
10. Dollar Value LIFO

Paul Zarowin 2
Cost Flow Assumptions
BI + Pur = Cost of Goods Available for Sale

Cost of Goods Ending

Sold (CGS)
+ Inventory (EI)

GAAP does not require specific identification of

the cost of each unit sold to its acquired cost.
Allocation of the Cost of Goods Available for
Sale between EI and CGS based on
assumptions like FIFO & LIFO.

Paul Zarowin 3
Illustrative Example
Beginning inventory: 200 units @ $10/unit = $2,000

Scenario 1: Stable Scenario 2: Rising

Prices Prices
Purchases Purchases Purchases
Quarter Units Unit cost Dollars Unit cost Dollars
1 100 $ 10 $ 1,000 $ 11 $ 1,100
2 150 $ 10 $ 1,500 $ 12 $ 1,800
3 150 $ 10 $ 1,500 $ 13 $ 1,950
4 100 $ 10 $ 1,000 $ 14 $ 1,400
500 $ 5,000 $ 6,250

Units sold: 100 units per quarter, or in total 400 units

Ending inventory: 300 units

Use of FIFO vs. LIFO makes a difference when prices

change.
Paul Zarowin 4
Illustrative Example (contd)
A. FIFO
The 400 units sold (CGS) are assumed to carry the earliest
costs incurred and the 300 units left in inventory carry that
latest costs.
CoGS Ending inventory
200 @ $ 10 = $2,000 100 @ $ 14 = $1,400
100 @ $ 11 = $1,100 150 @ $ 13 = $1,950
100 @ $ 12 = $1,200 50 @ $ 12 = $600
400 $4,300 300 $3,950

B. LIFO
The 400 units sold (CGS) are assumed to carry the latest
costs incurred and the 300 units left in inventory carry that
earliest costs.
CoGS Ending inventory
100 @ $ 14 = $1,400 200 @ $ 10 = $2,000
150 @ $ 13 = $1,950 100 @ $ 11 = $1,100
150 @ $ 12 = $1,800
400 $5,150 300 $3,100

Paul Zarowin 5
Reporting Trade-offs
FIFO vs. LIFO:
Inventories closer to replacement (current)
cost under FIFO reliable B/S
CoGS closer to replacement cost under LIFO
High quality of earnings

Price - hist. cost (Price - repl. cost) (repl. cost - hist. cost)

operating margin Holding gain(influences

(economic profit) only accounting
earnings)
Independent of
inventory method Dependent on use of
Paul ZarowinLIFO or FIFO 6
Reporting Trade-offs (contd)
I/S perspective (CoGS): LIFO vs.
FIFO
Example continued:
400 units were sold.

At replacement cost ((i.e., the 4th quarter

unit cost of $14) the CoGS equals 400 x $14

= $5,600
FIFO LIFO replacement cost
< <
$4,300 $5,150 $5,600

EX. P. 93 W/O LR
Paul Zarowin 7
 Reporting Trade-offs (contd)
B/S perspective (Inventory): FISH
vs. LISH
Ending inventory 300 units
At replacement cost ($14 per unit) inventory
has carrying value of: 300 x $14 = $4,200

Replacement cost FIFO/LISH LIFO/FISH

> >
$4,200 $3,950 $3,100

Ex. P. 93 w/o LR
Paul Zarowin 8
 LIFO Reserve (LR)
B/S perspective:

Approximates replacement
cost
LR InventoryFIFO - InventoryLIFO
LIFO layers: LR =LQL*(RC - HCL)
L=layer
Q=quantity (# of units)
RC=replacement cost (current price per unit)
HC=historical cost per unit

Paul Zarowin 9
LIFO Layers
B.B. E.B.
Inventor Inventor
y 2000 y 2000
$35
0
1999: bought 100 75 units
units for $3 each, worth Di
and sold 25 $225 p
2000
1998: bought 100 50 units $12 Bought 100
5 units for $4 25 units
units for $2 each, worth
each, and
and sold 50 $100 sold 200
worth $75

units $50
$25 25 units $25
1997: bought 100 worth
25 units
units for $1 each, $25
worth $25
and sold 75

Paul Zarowin 10
LIFO Reserve (contd)
I/S perspective:
current year current year
LR CGS
year 1
LIFO CGS
year 1
FIFO (pre-tax earnings)

i.e. cumulative difference in CGS.

Why?
current year Current year

year 1
GAS EI CGS
year 1

current year current year

LR EI LIFO EI FIFO CGS
year 1
FIFO CGS
year 1
LIFO

Paul Zarowin 11
Why do we care about in
LIFOFIFO:Reserve?
BI + PU = EI + CGS
R
- BI + PU = EI + CGS
LIFO: R
LR LR 0 B= LR
LR E +- LR
B CGS+ LIFO - CGS
(CGS
E -CGS
FIFO )
FIFO LIFO

LR 0 CGSFIFO CGSLIFO
LR 0 CGSFIFO CGSLIFO
Note: FIFO CGS can be > LIFO CGS
Key assumption: same purchases. Reasonable?
Incentives?
Do LIFO vs. FIFO firms differ in inventory
*Adjust B/S by LR
management? *Adjust I/S by LR
Paul Zarowin 12
Ex. P9-3; P9-8; P9-13
Why do we care about in LIFO Reserve?
(contd)
Remember: LR =LQL*(RC - HCL)
So LR means Q and/or RC (HC is fixed)

Example:
LRB=100($1.5 - $1) = $50
Consider there 2 alternative scenarios:
1. Q 100 150 : LRE=150($1.5 - $1) =$75
2. RC $1.5 $2 : LRE=100($2 - $1) =$100
In general, both Q and RC may change.

Paul Zarowin 13
 LR: Price Effect and Quantity
Effect
LR Q(RC E - HC) Q B (RC E - RC B )
Q(RC E - HC) quantity effect (dip profit, realized holding gains)

Q B (RC E - RC B ) price(inflation) effect

What makes LIFO CGS > or < FIFO CGS?

i.e., What makes LR + or - ?

LIFO disclosures: must disclose quantity effect

if material. Why?
Ex. ARAL CO, pg. 454-462, P.9-15

Paul Zarowin 14
LIFO and Earnings
Management
What is under managements control?
Q? RCE ? HC? QB ? RCB?

LIFO liquidations
What about FIFO firms?

P9-5

Paul Zarowin 15
LIFO Tax Savings

LIFO tax savings LR Tax rate

(conservative: assumes 0%
interest)

Remember:
LR = cumulative difference in LIFO CGS vs. FIFO
CGS
C 9-2, 3
Paul Zarowin 16
 Switch FIFO LIFO
Switch from FIFO to LIFO: just go forward,
since cant replicate layers (i.e., dont know
cumulative effect)

Switch from LIFO to FIFO:

DR Inventory (LR)
CR Cash/taxes payable (LR*tax rate)
CR R/E LR* (1-tax rate)

Remember: cumulative effect accounting change

Note: pay no interest on tax savings

C 9-5 Weldotron Paul Zarowin 17

DVL: Dollar Value LIFO
How firms do LIFO
Keep records FIFO (replacement
cost)
Convert to LIFO using annual price
index
Ease of record keeping

Paul Zarowin 18
 DVL Example
Firm begins at 1-1-1992
FIFO CGS = 100,000 every year

YR $FIFO Pric Qty Qty DVL LR LR P Q LIFO

=RC e effect effec CGS
t
199 70,000 1.0 70,00 70,00 70,00 - - - - 100,00
2 0 0 0 0 0
199 90,300 1.0 86,00 16,00 86,80 3,500 3,500 3,500 0 103,50
3 DVL = LIFO @5BOY + (Q
0 * Price)0 0 Qty = RC Price 0
1993:
199 95,120
DVL: 86,8001.1
= 70,000 BI + 16,000*1.05 new layer
4 LR: 13,500 =690,300 - 86,800
P effect: 70,000 units * (1.05 - 1.00)
199 Q108,00 1.2because RC = HC for new units
effect: zero,
5 LIFO0CGS = FIFO
0 CGS + LR
199 95,000 1.2
6 5

Paul Zarowin 19
LIFO Correction J.E.
Put LIFO firm on FIFO:
DR Inventory (LR)
CR Cash or taxes/payable (LR*tax rate
%)
CR R/E
(LR* 1-T%)

[same as slide #17]

Paul Zarowin 20