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

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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.

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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.
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Illustrative Example (cont’d)
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

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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 only

(economic profit) accounting earnings)

Independent of Dependent on use of LIFO

inventory method or FIFO
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Reporting Trade-offs (cont’d)
 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
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 Reporting Trade-offs (cont’d)
 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
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 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

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LIFO Layers
B.B. E.B.
Inventory Inventory
2000 2000
$350

1999: bought 100 Dip

75 units
units for $3 each, and
worth $225
sold 25
2000
$125
Bought 100
1998: bought 100 units for $4
50 units
units for $2 each, and each, and sold $75
worth $100 25 units
sold 50 200 units
worth $50
$25 $25
25 units
1997: bought 100
25 units worth $25
units for $1 each, and
worth $25
sold 75

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LIFO Reserve (cont’d)
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

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Why do we care about  in
LIFO Reserve?
FIFO: BI + PUR = EI + CGS
- LIFO: BI + PUR = EI + CGS
LRB + 0 = LRE + (CGSFIFO-CGSLIFO)

LR  LR E - LR B  CGSLIFO - CGSFIFO

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 management?

Ex. P9-3; P9-8; P9-13 *Adjust B/S by LR

*Adjust I/S by LR
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Why do we care about  in LIFO Reserve? (cont’d)
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.

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 LR: Price Effect and Quantity Effect
LR  Q(RC E - HC)  Q B (RC E - RC B )
Q(RCE - 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

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LIFO and Earnings Management
 What is under management’s control? 
Q? RCE ? HC? QB ? RCB?

 LIFO liquidations
 What about FIFO firms?

P9-5

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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
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 Switch FIFO  LIFO
 Switch from FIFO to LIFO: just go forward, since
can’t replicate layers (i.e., don’t 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

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

YR $FIFO Price Qty Qty DVL LR LR P Q LIFO

=RC effect effect CGS
1992 70,000 1.00 70,000 70,000 70,000 - - - - 100,000
1993 90,300 1.05 86,000 16,000 86,800 3,500 3,500 3,500 0 103,500
1994 95,120 1.16
1995 DVL
108,000
= LIFO @1.20
BOY + (Q * Price)   Qty = RC ÷ Price
1993:
1996
 95,000
DVL: 86,800 1.25
= 70,000 BI + 16,000*1.05 new layer
 LR: 13,500 = 90,300 - 86,800
 P effect: 70,000 units * (1.05 - 1.00)
 Q effect: zero, because RC = HC for new units
 LIFO CGS = FIFO CGS + LR

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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]

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