Benchmark Methods of Inventory Costing


Specific Identification

The theoretical basis for valuing inventories and cost of goods sold requires assigning the production and/or acquisition costs to the specific goods to which they relate. For example, the cost of ending inventory for an entity in its first year, during which it produced ten items (e.g., exclusive single family homes), might be the actual production cost of the first, sixth, and eighth unit produced if those are the actual units still on hand at the balance sheet date. This method of inventory valuation is usually referred to as specific identification.

Specific identification is generally not a practical technique, as the product will generally lose its separate identity as it passes through the production and sales process. Exceptions to this would arise in situations involving small inventory quantities with high unit value and low turnover rate. Under IAS 2, specific identification must be employed to cost inventories that are not ordinarily interchangeable, and goods and services produced and segregated for specific projects. For inventories meeting either of these criteria, the specific identification method is mandatory and the other benchmark methods cannot be used.

Because of the limited applicability of specific identification, it is more likely to be the case that certain assumptions regarding the cost flows associated with inventory will need to be made. One of accounting's peculiarities is that these cost flows may or may not reflect the physical flow of inventory. Over the years, much attention has been given to both the flow of physical goods and the assumed flow of costs associated with those goods. In most jurisdictions, it has long been recognized that the flow of costs need not mirror the actual flow of the goods with which those costs are associated. For example, a key provision in an early US accounting standard stated that

  • ...cost for inventory purposes shall be determined under any one of several assumptions as to the flow of cost factors; the major objective in selecting a method should be to choose the one which, under the circumstances, most clearly reflects periodic income.

Under international accounting standards, there are two benchmark cost flow assumptions, and one additional method, which is an allowed alternative treatment. The most common cost flow assumptions used are: (1) first-in, first-out (FIFO), (2) weighted-average, and (3) last-in, first-out (LIFO). Additionally, there are variations of each of these assumptions that have commonly been used in practice. In certain jurisdictions, other costing procedures, such as the base stock method, have also been permitted.

First-In, First-Out (FIFO)

The FIFO method of inventory valuation assumes that the first goods purchased are the first goods used or sold, regardless of the actual physical flow. This method is thought to parallel most closely the physical flow of the units for most industries having moderate to rapid turnover of goods. The strength of this cost flow assumption lies in the inventory amount reported on the balance sheet. Because the earliest goods purchased are the first ones removed from the inventory account, the remaining balance is composed of items acquired at more recent costs. This yields results similar to those obtained under current cost accounting on the balance sheet. However, the FIFO method does not necessarily reflect the most accurate income figure when viewed from the perspective of underlying economic performance, as older historical costs are being matched against current revenues. Depending on the rate of inventory turnover and the speed with which general and specific prices are changing, this mismatching could potentially have a material distorting effect on reported income. At the extreme, if reported earnings are fully distributed to owners as dividends, the enterprise could be left without sufficient resources to replenish its inventory stocks due to changing prices.

The following example illustrates the basic principles involved in the application of FIFO:

Units available

Units sold

Actual unit cost

Actual total cost

Beginning inventory

100

--

$2.10

$210

Sale

--

75

--

--

Purchase

150

--

2.80

420

Sale

--

100

--

--

Purchase

50

--

3.00

150

  • Total

300

175

$780

Given these data, the cost of goods sold and the ending inventory balance are determined as follows:

Units

Unit cost

Total cost

Cost of goods sold

100

$2.10

$210

75

2.80

210

175

$420

Ending inventory

50

3.00

$150

75

2.80

210

125

$360

Notice that the total of the units in cost of goods sold and ending inventory, as well as the sum of their total costs, is equal to the goods available for sale and their respective total costs.

The unique characteristic of the FIFO method is that it provides the same results under either the periodic or perpetual system. This will not be the case for any other costing method.

Weighted-Average

The other benchmark method of inventory valuation under IAS 2 involves averaging and is commonly referred to as the weighted-average method. The cost of goods available for sale (beginning inventory and net purchases) is divided by the units available for sale to obtain a weighted-average unit cost. Ending inventory and cost of goods sold are then priced at this average cost. For example, assume the following data:

Units available

Units sold

Actual unit cost

Actual total cost

Beginning inventory

100

--

$2.10

$210

Sale

--

75

--

--

Purchase

150

--

2.80

420

Sale

--

100

--

--

Purchase

50

--

3.00

150

  • Total

300

175

$780

The weighted-average cost is $780/300, or $2.60. Ending inventory is 125 units at $2.60, or $325; cost of goods sold is 175 units at $2.60, or $455.

When the weighted-average assumption is applied to a perpetual inventory system, the average cost is recomputed after each purchase. This process is referred to as a moving average. Sales are costed at the most recent average. This combination is called the moving average method and is applied below to the same data used in the weighted-average example above.

Units on hand

Purchases in dollars

Sales in dollars

Total cost

Inventory unit cost

Beginning inventory

100

$ --

$ --

$210.00

$2.10

Sale (75 units @ $2.10)

25

--

157.50

52.50

2.10

Purchase (150 units, $420)

175

420.00

--

472.50

2.70

Sale (100 units @ $2.70)

75

--

270.00

202.50

2.70

Purchase (50 units, $150)

125

150.00

--

352.50

2.82

Cost of goods sold is 75 units at $2.10 and 100 units at $2.70, or a total of $427.50.

Last-In, First-Out (LIFO)

The LIFO method of inventory valuation costs the ending inventory as if the last goods purchased were the first goods used or sold. This allows the matching of current costs with current revenue and as proponents of the method argue, provides the best measure of periodic income, which is a major objective for periodic financial reporting. However, unless costs remain relatively unchanged, the LIFO method will usually distort the ending inventory balance for balance sheet purposes because inventory usually consists of costs from earlier periods. Critics of the method also point out that LIFO does not usually follow the physical flow of merchandise or materials. However, this last argument should not affect the selection of a cost flow assumption, because the matching of physical flow is not considered to be an objective of accounting for inventories.

Despite the arguable logic of using a LIFO cost flow assumption during periods of changing prices, to achieve a more meaningful measure of income, the method actually is not truly derived from a promulgated accounting principle. Rather, the basis for LIFO is found in various tax codes enacted in certain jurisdictions from time to time. Since rising general price levels have been almost the rule during the past half century, LIFO has been enacted as a form of tax relief by a number of important tax jurisdictions and was widely embraced for financial reporting purposes principally in those instances in which use for tax reporting purposes was linked to financial reporting. Other requirements of LIFO, largely dependent on local tax regulations, have included restrictions on abandoning the LIFO after first adopting it, and limitations on supplementary disclosures of income determined by alternative costing strategies. Given LIFO's genesis as an offspring of tax rules, the precise methods of applying LIFO that are permitted in different nations will vary widely; the following discussion sets forth many of the computational techniques that may validly be employed, but does not represent which, if any, may be permitted in any particular circumstance. (IAS 2 does not describe how LIFO is to be operationalized.)

The actual implementation of LIFO requires valuation of the quantity of ending inventory at prices in effect earlier. The quantity of ending inventory on hand in the year when the method is first applied is termed the base layer. This inventory is valued at actual (full absorption) cost, and unit cost is determined by dividing total cost by the quantity on hand. In subsequent periods, increases in the quantity of inventory on hand are referred to as increments, or LIFO layers. These increments are valued individually by applying one of several possible costs to the quantity of inventory representing a layer.

  1. The actual cost of the goods most recently purchased or produced

  2. The actual cost of the goods purchased or produced in order of acquisition

  3. An average unit cost of all goods purchased or produced during the current year

  4. A hybrid method that will more clearly reflect income

Thus, after using the LIFO method for five years, it is possible that an enterprise could have ending inventory consisting of the base layer and five additional layers (or increments) provided that the quantity of ending inventory increased every year.

Example of the single goods (unit) LIFO approach

start example

Fenetre Co. is in its first year of operation and elects to use the periodic LIFO method of inventory valuation. The company sells only one product. Fenetre will apply the LIFO method using the order of current year acquisition cost. The following data are given for years 1 through 3:

Year 1

Units

Unit cost

Total cost

Purchase

200

$2.00

$400

Sale

100

--

--

Purchase

200

3.00

600

Sale

150

--

--

Year 2

Purchase

300

$3.20

$960

Sale

200

--

--

Purchase

100

3.30

330

Year 3

Purchase

100

$3.50

$350

Sale

200

--

--

Sale

100

--

--

In year 1 the following occurred:

  1. The total goods available for sale were 400 units.

  2. The total sales were 250 units.

  3. Therefore, the ending inventory was 150 units.

The ending inventory is valued at the earliest current year acquisition cost of $2.00 per unit. Thus, ending inventory is valued at $300 (150 x $2.00).

Another way to look at this is to analyze both cost of goods sold and ending inventory.

Units

Unit cost

Total cost

Cost of goods sold

200

$3.00

$600

50

2.00

100

250

$700

Ending inventory

150

$2.00

$300

Note that the base-year cost is $2.00 and that the base-year level is 150 units. Therefore, if ending inventory in the subsequent period exceeds 150 units, a new layer will be created.

Year 2

Units

Unit cost

Toted cost

Cost of goods sold

100

$3.30

$330

100

3.20

320

200

$650

Ending inventory

150

$2.00

$300

200

3.20

640

350

$940

Now, if ending inventory exceeds 350 units in the next period, a new layer will be created.

Year 3

Units

Unit cost

Total cost

Cost of goods sold

100

$3.50

$350

200

3.20

640

300

$990

Ending inventory base year

150

$2.00

$300

Notice how the decrement of 200 units in year 3 eliminated the entire year 2 increment. Thus, any year 4 increase in the quantity of inventory would result in a new increment that would be valued at year 4 prices.

end example

In situations where the ending inventory decreases from the level established at the close of the preceding year, the enterprise experiences a decrement or LIFO liquidation. Decrements will reduce or eliminate previously established LIFO layers. Once any part of a layer has been eliminated, it cannot be reinstated. For example, if in its first year after the election of LIFO an enterprise establishes a layer (increment) of ten units, in the next year inventory decreases by four units, leaving the first layer at six units, the enterprise cannot reestablish the first layer (back up to ten units) in the year that inventory next increases. Rather, it will be forced to create a new layer for the increase. The effect of LIFO liquidations in periods of rising prices is to release costs, which are significantly below the current cost being paid, into cost of goods sold from ending inventory. Thus, the resultant effect of a LIFO liquidation is to increase income, typically for both accounting and tax purposes (since most jurisdictions demand conformity between financial reporting and tax reporting). Because of this, LIFO is most commonly used by industries in which inventories are maintained or increased over time.

LIFO liquidations can take two forms, voluntary or involuntary. A voluntary liquidation exists when an enterprise decides, for one reason or another, to let inventory levels drop. Such a liquidation occurs because current prices may be too high, less inventory is needed for efficient production, or because of a transition in the product lines. Involuntary LIFO liquidations stem from reasons beyond the control of the enterprise, such as a strike, shortages, or shipping delay. Regardless of the reason, all liquidations result in a corresponding increase in income (assuming a trend of rising costs).

To compute the effect of the liquidation, the company must compute the difference between actual cost of sales and what cost of sales would have been had the inventory been reinstated. The Internal Revenue Service has ruled that this hypothetical reinstatement must be computed under the company's normal pricing procedures for valuing its LIFO increments. In the example above, the effect of the year 3 LIFO liquidation would be computed as follows:

  • Inventory reinstatement:

    • 200 units @ $3.50 - $3.20 = $60

Because the 200 units liquidated would have been stated at the year 3 price of $3.50 if there had been an increment, the difference between $3.50 and the actual amount charged to cost of sales for these units ($3.20) measures the effect of the liquidation.

An inordinate amount of recordkeeping is required in applying the unit LIFO method. Remember that the illustration above involved only one product. The recordkeeping burden becomes much greater as the number of products increases. For this reason, a pooling approach is generally applied to LIFO inventories.

Pooling is the process of grouping items that are naturally related and then treating this group as a single unit in determining the LIFO cost. Because the quantity of ending inventory includes many more items, decreases in one item can be made up for by increases in others, whereas under the single goods unit approach a decrease in any one item results in a liquidation of LIFO layers.

The problem in applying the pooling method emanates from the tax regulations, not the practical side of application. In applying LIFO, the tax regulations state that each type of good in the opening inventory must be compared with a similar type in the closing inventory. These items must be similar as to character, quality, and price. This qualification has generally been interpreted to mean identical. The effect of this statement is to require a separate pool for each item under the unit LIFO method. The need for a simpler, more practical approach to using the LIFO concept and allowing for a greater use of the pooling concept was met by dollar-value LIFO.

Dollar-Value LIFO

Dollar-value LIFO may be employed in those jurisdictions where it is permitted by the tax or other regulatory authorities. The dollar-value LIFO method of inventory valuation determines the cost of inventories by expressing base-year costs in terms of total dollars rather than specific prices of specific units. As discussed later, the dollar-value method also gives rise to an expanded interpretation of the use of pools. Increments and liquidations are treated the same but are reflected only in terms of a net liquidation or increment for the entire pool.

Creating pools.

Essentially three alternatives exist for determining pools under dollar-value LIFO: (1) the natural business unit, (2) multiple pools, and (3) pools for wholesalers, retailers, jobbers, and so on.

The natural business unit is defined by the existence of separate and distinct processing facilities and operations and the maintenance of separate income (loss) records. The concept of the natural business unit is generally dependent on the type of product, not the various stages of production for that project. Thus, the pool can (and will) contain raw materials, WIP, and finished goods. The three examples below, taken from treasury regulations, illustrate the application of the natural business unit concept.

Example 1

start example

A corporation manufactures, in one division, automatic clothes washers and dryers of both commercial and domestic grade as well as electric ranges, mangles, and dishwashers. The corporation manufactures, in another division, radios and television sets. The manufacturing facilities and processes used in manufacturing radios and television sets are distinct from those used in manufacturing automatic clothes washers, for example. Under these circumstances, the enterprise would consist of two business units and two pools would be appropriate: one consisting of all of the LIFO inventories involved with the manufacture of clothes washers and dryers, electric ranges, mangles, and dishwashers, and the other consisting of all the LIFO inventories involved with the production of radios and television sets.

end example

Example 2

start example

An enterprise produces plastics in one of its plants. Substantial amounts of the production are sold as plastics. The remainder of the production is shipped to a second plant of the enterprise for the production of plastic toys that are sold to customers. The company operates its plastics plant and toy plant as separate divisions. Because of the different product lines and the separate divisions, the enterprise has two natural business units.

end example

Example 3

start example

A company is engaged in the manufacture of paper. At one stage of processing, uncoated paper is produced. Substantial amounts of uncoated paper are sold at this stage of processing. The remainder of the uncoated paper is transferred to the company's finishing mill, where coated paper is produced and sold. This company has only one natural business unit since coated and uncoated paper are within the same product line.

end example

The multiple-pooling method is the grouping of substantially similar items. In determining substantially similar items, consideration should be given to the processing applied, the interchangeability, the similarity of use, and the customary practice of the industry. While the election of multiple pools will necessitate additional recordkeeping, it may result in a better estimation of periodic income. Depending on local tax regulations, diverse inventory types such as inventory items of wholesalers, retailers, jobbers, and distributors might be required to be placed into pools by major lines, types, or classes of goods.

All three methods of pooling allow for a change in the components of inventory. New items that properly fall within the pool may be added, and old items may disappear from the pool, but neither will necessarily effect a change in the total dollar value of the pool.

Computing dollar-value LIFO.

The purpose of the dollar-value LIFO method of valuing inventory is to convert inventory that is priced at end-of-year prices to that same inventory priced at base-year (or applicable LIFO layer) prices. The dollar-value method achieves this result through the use of a conversion price index. The inventory at current year cost is divided by the appropriate index to arrive at the base-year cost. Thus, the main focus is on the determination of the conversion price index. There are three basic methods that can be used in computation of the LIFO value of a dollar-value pool: (1) double-extension, (2) link-chain, and (3) the index method. Each of these is discussed below with examples provided where appropriate.

Double-extension method.

This was the method originally developed to compute the conversion price index. It involves extending the entire quantity of ending inventory for the current year at both base-year prices and end-of-year prices to arrive at a total dollar value for each, hence the title of double-extension. The end-of-year dollar total is then divided by the base-year dollar total to arrive at the index, usually referred to as the conversion price index. This index indicates the relationship between the base-year and current prices in terms of a percentage. Each layer (or increment) is valued at its own percentage. Although a representative sample is allowed (meaning that not all of the items need be double-extended; this is discussed in more detail under indexing), the recordkeeping under this method is very burdensome. The base-year price must be kept for each inventory item. Depending on the number of different items included in the inventory of the company, the necessary records may be too detailed to keep past the first year.

The following example illustrates the double-extension method of computing the LIFO value of inventory. The example presented is relatively simple and does not attempt to incorporate all of the complexities of inventory accounting.

Example of the double-extension LIFO method

start example

Van de Voort, Inc. uses the dollar-value method of LIFO inventory valuation and computes its price index using the double-extension method. Van de Voort has a single pool that contains two inventory items, A and B. Year 1 is the company's initial year of operations. The following information is given for years 1 through 4:

Year

Ending inventory current prices

Ending quantity (units) and current price

A

B

1

$100,000

5,000

$6.00

7,000

$10.00

2

120,300

6,000

6.30

7,500

11.00

3

122,220

5,800

6.40

7,400

11.50

4

133,900

6,200

6.50

7,800

12.00

In year 1 there is no computation of an index; the index is 100%. The LIFO cost is the same as the actual current year cost. This is our base year.

In year 2 the first step is to double-extend the quantity of ending inventory at base-year and current year costs. This is illustrated below.

Item

Quantity

Base-year cost/unit

Extended

Current year cost/unit

Extended

A

6,000

$ 6.00

$ 36,000

$ 6.30

$ 37,800

B

7.500

10.00

75,000

11.00

82,500

$111,000

$120.300[a]

[a]When using the double-extension method and extending all the inventory items to arrive at the index, this number must equal the ending inventory at current prices. If a sampling method is used (as discussed under indexing), this number divided by your ending inventory at current prices will give you the percentage sampled.

Now we can compute the conversion price index that is

In this case

Next, the year 2 layer at the base-year cost is computed by taking the current year ending inventory at base-year prices (if only a sample of the inventory is extended, this number is arrived at by dividing the ending inventory at current year prices by the conversion price index) of $111,000 and subtracting the base-year cost of $100,000. In year 2 there is an increment (layer) of $11,000 at base-year costs.

The year 2 layer of $11,000 at base-year cost must be converted so that the layer is valued at the prices in effect when it came into existence (i.e., at year 2 prices). This is done by multiplying the increment at base-year cost ($11,000) by the conversion price index (1.08). The result is the year 2 layer at LIFO prices.

Base-year cost

$100,000

Year 2 layer ($11,000 x 1.084)

11,924

$111,924

In year 3 the same basic procedure is followed.

Item

Quantity

Base-year cost/unit

Extended

Current year cost/unit

Extended

A

5,800

$ 6.00

$ 34,800

$ 6.40

$ 37,120

B

7,400

10.00

74,000

11.50

85,100

$108,800

$122,200

There has been a decrease in the base-year cost of the ending inventory, which is referred to as a decrement. A decrement results in the decrease (or elimination) of layers provided previously. In this situation, computation of the index is not necessary, as there is no LIFO layer that requires valuation. If a sampling approach has been used, the index is needed to arrive at the ending inventory at base-year cost and thus to determine if there has been an increment or a decrement.

Now the ending inventory at base-year cost is $108,800. The base-year cost is still $100,000, so the total increment is $8,800. Since this is less than the $11,000 increment of year 2, no additional increment is established in year 3. The LIFO cost of the inventory is as shown below.

Base-year cost

$100,000

Year 2 layer ($8,800 x 1.084)

9,539

$109,539

The fourth year then follows the same steps.

Item

Quantity

Base-year cost/unit

Extended

Current year cost/unit

Extended

A

6,200

$ 6.00

$ 37,200

$ 6.50

$ 40,300

B

7,800

10.00

78,000

12.00

93,600

$115,200

$133,900

The conversion price index is 116.2% (133,900/115,200).

A current year increment exists because the ending inventory at base-year prices in year 4 of $115,200 exceeds the year 3 number of $108,800. The current year increment of $6,400 must be valued at year 4 prices. Thus the LIFO cost of the year 4 inventory is

Base-year cost

$100,000

Year 2 layer ($8,800 x 1.084)

9,539

Year 4 layer ($6,400 x 1.162)

7,437

$116,976

It is important to point out that once a layer is reduced or eliminated, it is never replaced (as with the year 2 increment).

end example

Link-chain method.

As shown in this example, the computations for application of the double-extension method become arduous even if only a few items exist in the inventory. Also, consider the problems that arise when there is a constant change in the inventory mix or in situations in which the breadth of the inventory is large. The link-chain method of applying dollar-value LIFO was developed to combat these problems.

Another purpose served by the link-chain method is to eliminate the problem created by a significant turnover in the components of inventory. Under the double-extension or indexing method, it is presumed that any new products added to the inventory will be costed at base-year prices. If these are not available, the earliest cost available after the base year is used. If the item was not in existence in the base year, the reporting entity will attempt to reconstruct the base cost, using a reasonable method to determine what the cost would have been if the item had been in existence in the base year. Although this might not appear to be a problem upon first consideration, imagine identifying a cost from a base period twenty-five to fifty years past. Should that be impossible, a more recent cost would have to be identified to serve as the base-year cost value, which would eliminate some of the LIFO benefit.

Also imagine a situation faced by a high-tech industry where inventory is continually being replaced by newer, more advanced products. The effect of this rapid change under the double-extension method (because the new products did not exist in the base period) is to use current prices as base-year costs. Thus, when inventory has such a rapid turnover, the LIFO advantage is nonexistent, as current and base-year costs are sometimes synonymous. This is the major reason for the development of the link-chain method.

The link-chain method is the process of developing a single cumulative index that is applied to the ending inventory amount priced at the beginning-of-the-year costs. A separate cumulative index is used for each pool regardless of the variations in the components of these pools over the years. Technological change is allowed for by the method used to calculate each current year index. The index is derived by double-extending a representative sample (between 50% and 75% of the dollar value of the pool is generally thought to be appropriate) at both beginning-of-year prices and end-of-year prices. This annual index is then applied (multiplied) to the previous period's cumulative index to arrive at the new current year cumulative index.

Example of the link-chain method

start example

Notice that the end-of-year costs and inventory quantity used are the same as those used in the double-extension example. Assume the following inventory data for years 1 to 4. Year 1 is assumed to be the initial year of operation for the company. The LIFO method is elected on the first tax return. Assume that A and B constitute a single pool.

Product

Ending inventory quantity

Cost per unit

Extension

Beg. of yr.

End of yr.

Beginning

End

Year 1:

A

5,000

N/A

$ 6.00

N/A

30,000

B

7,000

N/A

10.00

N/A

70,000

Year 2:

A

6,000

$ 6.00

6.30

36,000

37,800

B

7,500

10.00

11.00

75,000

82,500

Year 3:

A

5,800

6.30

6.40

36,540

37,120

B

7,400

11.00

11.50

81,400

85,100

Year 4:

A

6,200

6.40

6.50

39,680

40,300

B

7,800

11.50

12.00

89,700

93,600

The initial year (base year) does not require the computation of an index under any LIFO method. The base-year index will always be 1.00.

Thus, the base-year inventory layer is $100,000 (the end-of-year inventory restated at base-year cost).

The second year requires the first index computation. Notice that in year 2 our extended totals are

Beginning-of -year prices

End-of-year prices

A

$ 36,000

$ 37,800

B

75,000

82,500

$111,000

$120,300

The year 2 index is 1.084 (120,300/111,000). This is the same as computed under the double-extension method because the beginning-of-the-year prices reflect the base-year price. This will not always be the case, as new items may sometimes be added to the pool, causing a change in the index.

Thus, the cumulative index is the 1.084 current year index multiplied by the preceding year index of 1.00 to arrive at a link-chain index of 1.084.

This index is then used to restate the inventory to base-year cost by dividing the inventory at end-of-year dollars by the cumulative index: $120,300/1.084 = $111,000. The determination of the LIFO increment or decrement is then basically the same as the double-extension method. In year 2 the increment (layer) at base-year cost is $11,000 (S111,000 - 100,000). This layer must be valued at the prices effective when the layer was created, or extended at the cumulative index for that year. This results in an ending inventory at LIFO cost of

Base-year cost

Index

LIFO cost

Base year

$100,000

1.00

$100,000

Year 2 layer

11,000

1.084

11,924

$111,000

$111,924

The index for year 3 is computed as follows:

Beginning-of-year prices

End-of-year prices

A

$ 36,540

$ 37,120

B

81,400

85,100

$117,940

$122,220

122,220/117,940 = 1.036

The next step is to determine the cumulative index, which is the product of the preceding year's cumulative index and the current year index, or 1.123 (1.084 x 1.036). The new cumulative index is used to restate the inventory at end-of-year dollars to base-year cost. This is accomplished by dividing the end-of-year inventory by the new cumulative index. Thus, current inventory at base-year cost is $108,833. In this instance we have experienced a decrement (a decrease from the prior year's $111,000). The determination of ending inventory is

Base-year cost

Index

LIFO cost

Base year

$100,000

1.00

$100,000

Year 2 layer

8,833

1.084

9,575

Year 3 layer

--

1.123

--

$108,833

$109,575

Finally, perform the same steps for the year 4 computation. The current year index is 1.035 (133,900/129,380). The new cumulative index is 1.162 (1.035 x 1.123). The base-year cost of the current inventory is $115,232 (133,900/1.162). Thus, LIFO inventory at the end of year 4 is

Base-year cost

Index

LIFO cost

Base year

$100,000

1.00

$100,000

Year 2 layer

8,833

1.084

9,575.

Year 3 layer

--

1.123

--

Year 4 layer

6,399

1.162

7,435

$115,232

$117,010

end example

Notice how even though the numbers used were the same as those used in the double-extension example, the results were different (year 4 inventory under double-extension was $116,976); however, not by a significant amount. It is much easier to keep track of beginning-of-the-year prices than it is to keep base-year prices, but perhaps more important, it is easier to establish beginning-of-the-year prices for new items than to establish their base-year price. The latter reason is why the link-chain method is so much more desirable than the double-extension method. However, before electing or applying this method, a company must be able to establish a sufficient need as defined in the treasury regulations.

Finally, it should be noted that the link-chain method was originally developed for those enterprises that wanted to use LIFO but because of substantial changes in product lines over time were unable to recreate or keep the historical records necessary to make accurate use of the double-extension method. It is important to note that the double-extension and link-chain methods are not intended to be selective alternatives for the same situation. The link-chain election requires that substantial change in product line be evident over the years, and it is not meant to be used solely because of its ease of application. The double-extension method, which is more accurate, should be demonstrated to be impractical before the link-chain method is invoked as an alternative.

Indexing.

The last major alternative available for computing the dollar-value LIFO inventory is indexing. These indexing methods can basically be broken down into two types: (1) an internal index, and (2) an external index.

The internal index is merely a variation of the double-extension method. A representative sample (or some other statistical method) of the inventory will be double extended; the representative index computed from the sample is then used to restate the inventory to base-year cost and to value the new layer.

The external index method involves using indices published by governmental or private sources and applying the index chosen to the inventory figures. Because of this method's complexity and limited applicability, and due to the fact that local taxing authorities or other official agencies would have to endorse one or more indices for such use, this application is not discussed further.

The methods described for the application of LIFO, as noted above, have been based on tax rules rather than on financial accounting pronouncements. GAAP has tended to permit the use of LIFO when it has because it had earlier been endorsed by the taxing or other relevant authorities, not because of the theoretical validity of the technique, although it can be argued that LIFO does more accurately measure periodic income. In recognition of the lack of authoritative accounting guidelines in the implementation of LIFO in the United States, for example, the AICPA prepared an Issues Paper on this topic. This paper, Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories, described numerous accounting problems in the use of LIFO and included advisory conclusions for these problems. Because of the possible applicability of the guidance in this paper to those entities that choose to use the available alternative method under IAS 2, selected sections of it are detailed in the disclosure requirements at the end of this chapter.

Interim Treatment of LIFO

IAS 34 addresses the matter of interim financial reporting. Under this standard, an entity is to employ the same accounting policies for interim reporting purposes as are used for its annual financial statements. Furthermore, the standard stipulates that revenue and costs are to be recognized when they occur, and are not to be anticipated or deferred.

IAS 34 does not specifically address LIFO costing on interim bases. Notwithstanding the directive to apply the same measurement strategies to interim reporting as to annual reporting, LIFO does present some special problems in this regard. Effectively, LIFO was conceived of as a measurement strategy to be employed for financial reporting on a full fiscal year, and certain potentially distorting anomalies could occur if interim measurements were to be made. This principally results from liquidations of LIFO layers at interim dates which would force older, lower inventory costs into cost of sales, even if the inventory were fully replenished by year-end. If the correction were then incorporated into the year-end financials, the individual interim periods might be materially distorted (e.g., with exaggerated profits in the earlier period, and depressed results in the final interim period of the year).

Since international accounting standards do not, at present, address this problem, it may be instructive to look to US GAAP for advisory guidance. It suggests that, while year-end liquidations of LIFO cost layers must be dealt with as permanent declines, at interim dates these may be accounted for as temporary (assuming that this is supportable by the relevant facts and circumstances), with a "reserve" established for replenishment, thereby avoiding absorbing old, lower costs into cost of sales.

This situation perhaps highlights the fact that LIFO has little conceptual foundation and was actually developed principally as a tax-saving technique in periods of rising prices. Once sanctioned by the taxing authorities, LIFO eventually became a generally accepted accounting principle despite the fact that, with very few exceptions, the presumed "flow of costs" does not match the actual flow of goods. The IASB has indicated that it plans to review inventory costing, with the possible goal of narrowing the range of acceptable alternative methods. While it has not said specifically what changes might be forthcoming, it would not be surprising if LIFO were dropped from the ranks of approved costing methods.

Proposal to eliminate LIFO costing alternative.

The IASB, as part of its Improvements Project, has determined that the goals of achieving convergence among accounting standards and of promoting uniformity across entities reporting under IAS will be served by eliminating the current "allowed alternative" method of costing inventories, which uses the last-in, first-out (LIFO) method. If adopted, this will leave the first-in, first-out (FIFO) and the average costing methods as the two acceptable costing techniques under IAS (IFRS).

This proposal is controversial, not necessarily because there are many users that believe that the LIFO convention accurately portrays the physical flow of goods (which it rarely ever does) but rather because it provides tax advantages where it is permitted to be used, and the use of LIFO for tax purposes sometimes requires "conformity" in financial reporting. That is, some important taxing authorities, including that in the US, have allowed the use of LIFO for tax purposes (where, as explained above, in times of rising prices it results in the computation of a lower taxable income amount than do FIFO or average costing methods) but have made it contingent on also reporting LIFO-based earnings to shareholders and others. The loss of LIFO as a legitimate costing method for preparation of general-purpose external financial statements would, under many of the current laws, preclude its use for tax purposes.

It is not clear at this point what may be the ramifications of the move to ban LIFO under IAS, but in some instances it is not inconceivable that in nations where the LIFO conformity rule remains in effect, and which have not yet adopted IAS as the operative standard of financial reporting, this could dampen enthusiasm for such a change. More realistically, however, the multiple other (good) reasons for considering the endorsement of IAS might be manifested in efforts to effect changes to national tax laws, so that conformity rules might be relaxed. It is, however, too early to tell whether this will occur, and the most important jurisdiction where IAS are yet to be recognized—the US, where the LIFO conformity rule is in effect—has been resistant to allowing IAS-compliant financial reporting anyhow.

Comparison of Cost Assumptions

Of the three basic cost flow assumptions, LIFO and FIFO produce the most extreme results, with results using the weighted-average method generally falling somewhere in between. The selection of one of these methods involves a detailed analysis, including a determination of the organization's objectives and the current and future economic state.

As mentioned above, in periods of rising prices the LIFO method is generally thought best to fulfill the objective of providing the clearest measure of periodic income. It does not provide an accurate estimate of the inventory value in an inflationary environment; however, this can usually be overcome by the issuance of supplementary fair value data. In periods of rising prices, a prudent business should use the LIFO method because it will result in a decrease in the current tax liability when compared to other alternatives, for those jurisdictions where the use of LIFO is acceptable. Yet in a deflationary period, the opposite is true.

FIFO is a balance-sheet-oriented costing method, as it gives the most accurate estimate of the current value of the inventory account during periods of changing prices. In periods of rising prices, the FIFO method will result in higher taxes than the other alternatives, while in a deflationary period FIFO provides for a reduced tax burden. However, a major advantage of the FIFO method is that it is not subject to all the regulations and requirements of the tax codes as LIFO typically is.

The average methods do not provide an estimate of current cost information on either the balance sheet or income statement. The average method will not serve to minimize the tax burden, nor will it result in the highest burden among the various alternatives.

Although price trends and underlying objectives are important in the selection of a cost flow assumption, other considerations, such as the risk of LIFO liquidations, cash flow, and capital maintenance, are also important but were not mentioned above.

Net Realizable Value

As stated in IAS 2

  • Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

The utility of an item of inventory is limited to the amount to be realized from its ultimate sale; where the item's recorded cost exceeds this amount, GAAP requires that a loss be recognized for the difference. The logic for this requirement is twofold: first, assets (in particular, current assets such as inventory) should not be reported at amounts that exceed net realizable value; and second, any decline in value in a period should be reported in that period's results of operations in order to achieve proper matching with current period's revenues. Were the inventory to be carried forward at an amount in excess of net realizable value, the loss would be recognized on the ultimate sale in a subsequent period. This would mean that a loss incurred in one period, when the value decline occurred, would have been deferred to a different period, which would clearly be inconsistent with several key accounting concepts, including conservatism.

IAS 2 states that estimates of net realizable value should be applied on an item-by-item basis in most instances, although it makes an exception for those situations where there are groups of related products or similar items that can be properly valued in the aggregate. As a general principle, item-by-item comparisons of cost to net realizable value are required, lest unrealized "gains" on some items (i.e., where the net realizable values exceed historical costs) offset the unrealized losses on other items, thereby reducing the net loss to be recognized. Since recognition of unrealized gains in earnings is generally proscribed under GAAP. evaluation of inventory declines on a grouped basis would be an indirect or "backdoor" mechanism to recognize gains that should not be given such recognition. Accordingly, the basic requirement is to apply the net realizable value tests on an individual item basis.

In many jurisdictions, the term lower of cost or market is used, as contrasted to IAS 2's lower of cost or net realizable value. As a practical matter, this difference in terminology will have little or no impact, since market is usually defined operationally as being replacement cost or net realizable value. However, one important distinction is that market is usually defined as a conditional term that contemplates a range of values, based not only on the costs to complete and sell an item, but also, in some circumstances, on the expected or normal profit to be earned on the sale. Since IAS 2 provides only general guidance concerning the determination of net realizable value, it will be useful to look to other existing standards for insight into how these measures are to be developed in a practical situation.

Measuring the decline to net realizable value.

The IAS 2 definition of net realizable value makes explicit reference only to "costs of completion and costs incurred in order to make the sale." However, as illustrated below, if expected or normal profit margins on sales of inventory items are not taken into account, excessive profits or losses might be recognized in future periods, due to an incomplete application of the net realizable value concept.

The application of these principles is illustrated in the following example. In this example, replacement cost will be used as the primary operational definition of inventory value when that amount is lower than carrying value determined by historical cost. Replacement cost is a valid measure of the future utility of the inventory item since increases or decreases in the purchase price generally foreshadow related increases or decreases in the selling price. Assume the following information for products A, B, C, D, and E:

Item

Cost

Replacement cost

Est. selling price

Cost to complete

Normal profit percentage

A

$2.00

$1.80

$ 2.50

$0.50

24%

B

4.00

1.60

4.00

0.80

24%

C

6.00

6.60

10.00

1.00

18%

D

5.00

4.75

6.00

2.00

20%

E

1.00

1.05

1.20

0.25

12.5%

  • Consider item A: The net realizable value defined in accordance with IAS 2 is $2.50 - 0.50 = $2.00 (estimated selling price less costs to complete and sell). As it happens, this is exactly equal to historical cost, suggesting that there would be no adjustment required. However, if no adjustment is recorded, the profit realized upon the sale next period will be $2.50 - 2.00 - 0.50 = $0, which would be an unnaturally low net margin given the historical experience of a 24% margin. To preserve the normal margin, which would amount to $0.60 ($2.50 x 24%), the inventory would have to be written down to $1.40 ($2.50 - 0.50 - 0.60). However, the actual cost to replace the item in inventory is known to be $1.80, which suggests that the normal margin of 24% cannot be replicated under current conditions.

The foregoing explains why some standards setters and accounting theoreticians (but it should be stressed, not the IASC) have concluded that inventory should be reported at the lower of cost or market, where market is defined as replacement cost subject to ceiling and floor values; where ceiling is defined as net realizable value (NRV), and floor as the NRV minus the normal profit margin. Using this approach (which is the standard in the United States, Belgium, Canada, Germany, Italy, the Netherlands, and Spain, among other jurisdictions), the amount of profit to be recognized in the period of later sale, absent other changes in the marketplace after the reporting date, will not be abnormally high or low.

To continue with this example, the data in the foregoing table are used to compute market values consistent with the definition set forth earlier. Note that the primary measure in all cases is replacement cost; if this falls between the ceiling and the floor, it becomes the measure of market, which is then compared to historical cost; the lower of cost or market is then used to actually value the inventory item. If the replacement cost exceeds the ceiling value (as for items D and E), the ceiling value becomes the market next to be compared to historical cost. On the other hand, if replacement cost is lower than the floor (as for items B and C), the floor is used as the market value to be compared next to the historical cost.

Determination of Net Realizable Value

Item

Cost

Replacement cost

NRV (ceiling)

NRV less profit (floor)

Market

LCM

A

$2.00

$1.80

$2.00

$1.40

$1.80

$1.80

B

4.00

1.60

3.20

2.24

2.24

2.24

C

6.00

6.60

9.00

7.20

7.20

6.00

D

5.00

4.75

4.00

2.80

4.00

4.00

E

1.00

1.05

0.95

0.80

0.95

0.95

Note that under a strict reading of IAS 2, NRV would be compared directly to historical cost; the other values in the above table would not be given any consideration. However, it is the authors' opinion that there is sufficient flexibility in IAS 2 to permit some application of the principle of lower of cost or market as discussed above. If a strict application of the net realizable value rule were insisted upon, in contrast, item A would be valued at $2.00 instead of $1.80, resulting in a zero profit upon sale; and item B would be valued at $3.20 instead of $2.24, also resulting in a zero profit upon ultimate disposition. In general, the impact of using net realizable value, rather than market, would be to preclude preservation of some (if not a normal amount of) profit upon later sale of the item.

Recoveries of previously recognized losses.

IAS 2 stipulates that a new assessment of net realizable value should be made in each subsequent period; when the reason for a previous write-down no longer exists (i.e., when net realizable value has improved), it should be reversed. Since the write-down was taken into income, the reversal should also be reflected in earnings.

Other Valuation Methods

There are instances in which an accountant must estimate the value of inventories. Whether for interim financial statements or as a check against perpetual records, the need for an inventory valuation without an actual physical count is required. Some of the methods used, which are discussed below, are the retail method, the LIFO retail method, and the gross profit method.

Retail method.

IAS 2 notes that the retail method may be used by certain industry groups but does not provide details on how to employ this method, nor does it address the many variations of the technique. The conventional retail method is used by retailers as a method to estimate the cost of their ending inventory. The retailer can either take a physical inventory at retail prices or estimate ending retail inventory and then use the cost-to-retail ratio derived under this method to convert the ending inventory at retail to its estimated cost. This eliminates the process of going back to original invoices or other documents to determine the original cost for each inventoriable item. The retail method can be used under any of the three cost flow assumptions discussed earlier: FIFO, LIFO, or average cost. As with ordinary FIFO or average cost, the LCM rule can also be applied to the retail method when either one of these two cost assumptions is used.

The key to applying the retail method is determining the cost-to-retail ratio. The calculation of this number varies depending on the cost flow assumption selected. Essentially, the cost-to-retail ratio provides a relationship between the cost of goods available for sale and the retail price of these goods. This ratio is used to convert the ending retail inventory back to cost. Computation of the cost-to-retail ratio for each of the available methods is described below. The use of the LIFO cost flow assumption with this method is discussed in the next section and, therefore, is not addressed in this listing.

  1. FIFO cost— The concept of FIFO indicates that the ending inventory is made up of the latest purchases; therefore, beginning inventory is excluded from computation of the cost-to-retail ratio, and the computation becomes net purchases divided by their retail value adjusted for both net markups and net markdowns.

  2. FIFO (using a lower of cost or market approach)— The computation is basically the same as FIFO cost except that markdowns are excluded from the computation of the cost-to-retail ratio.

  3. Average cost— Average cost assumes that ending inventory consists of all goods available for sale. Therefore, the cost-to-retail ratio is computed by dividing the cost of goods available for sale (Beginning inventory + Net purchases) by the retail value of these goods adjusted for both net markups and net markdowns.

  4. Average cost (using a lower of cost or market approach)— This is computed in the same manner as average cost except that markdowns are excluded for the calculation of the cost-to-retail ratio.

A simple example illustrates the computation of the cost-to-retail ratio under both the FIFO cost and average cost methods in a situation where no markups or markdowns exist.

FIFO cost

Average cost

Cost

Retail

Cost

Retail

Beginning inventory

$100,000

$ 200,000

$100,000

$ 200,000

Net purchases

500,000

800,000

500,000

800,000

  • Total goods available for sale

$600,000

1,000,000

$600,000

1,000,000

Sales at retail

(800,000)

(800,000)

Ending inventory at retail

$ 200,000

$200,000

Cost-to-retail ratio

= 62.5%

= 60%

Ending inventory at cost

  • 200,000 x 0.625

$ 125,000

  • 200,000 x 0.60

$120,000

Note that the only difference in the two examples is the numbers used to calculate the cost-to-retail ratio.

As shown above, the lower of cost or market aspect of the retail method is a result of the treatment of net markups and net markdowns. Net markups (markups less markup cancellations) are net increases above the original retail price, which are generally caused by changes in supply and demand. Net markdowns (markdowns less markdown cancellations) are net decreases below the original retail price. An approximation of lower of cost or market is achieved by including net markups but excluding net markdowns from the cost-to-retail ratio.

To understand this approximation, assume that a toy is purchased for $6 and the retail price is set at $10. It is later marked down to $8. A cost-to-retail ratio including markdowns would be $6 divided by $8 or 75%, and ending inventory would be valued at $8 times 75%, or $6 (original cost). A cost-to-retail ratio excluding markdowns would be $6 divided by $10 or 60%, and ending inventory would be valued at $8 times 60%, or $4.80 (on a lower of cost or market basis). The write-down to $4.80 reflects the loss in utility that is evidenced by the reduced retail price.

The application of the lower of cost or market rule is illustrated for both the FIFO and average cost methods in the example below. Remember, if the markups and markdowns below had been included in the preceding example, both would have been included in the cost-to-retail ratio.

FIFO cost (LCM)

Average cost (LCM)

Cost

Retail

Cost

Retail

Beginning inventory

$100,000

$ 200,000

$100,000

$ 200,000

Net purchases

500,000

800,000

500,000

800,000

Net markups

--

250,000

--

250,000

Total goods available for sale

$600,000

1,250,000

$600,000

1,250,000

Net markdowns

(50,000)

(50,000)

Sales at retail

(800,000)

(800,000)

Ending inventory at retail

$ 400,000

$ 400,000

Cost-to-retail ratio

= 47.6%

= 48%

Ending inventory at cost

  • 400,000 x 0.476

$ 190,400

  • 400,000 x 0.48

$ 192,000

Notice that under the FIFO (LCM) method all of the markups are considered attributable to the current period purchases. Although this is not necessarily accurate, it provides the most conservative estimate of the ending inventory.

There are a number of additional inventory topics and issues that affect the computation of the cost-to-retail ratio and, therefore, deserve some discussion. Purchase discounts and freight affect only the cost column in this computation. The sales figure that is subtracted from the adjusted cost of goods available for sale in the retail column must be gross sales after adjustment for sales returns. If sales are recorded at gross, deduct the gross sales figure. If sales are recorded at net, both the recorded sales and sales discount must be deducted to give the same effect as deducting gross sales (i.e., sales discounts are not included in the computation). Normal spoilage is generally allowed for in the firm's pricing policies, and for this reason it is deducted from the retail column after calculation of the cost-to-retail ratio. Abnormal spoilage, on the other hand, should be deducted from both the cost and retail columns before the cost-to-retail calculation, as it could distort the ratio. It is then generally reported as a loss separate from the cost of goods sold section. Abnormal spoilage is generally considered to arise from a major theft or casualty, while normal spoilage is usually due to shrinkage or breakage. These determinations and their treatments will vary depending on the firm's policies.

When applying the retail method, separate computations should be made for any departments that experience significantly higher or lower profit margins. Distortions arise in the retail method when a department sells goods with varying margins in a proportion different from that purchased, in which case the cost-to-retail percentage would not be representative of the mix of goods in ending inventory. Also, manipulations of income are possible by planning the timing of markups and markdowns.

The retail method is an acceptable method of valuing inventories for tax purposes in some, but not all, jurisdictions. The foregoing examples are not meant to imply that the method would be usable in any given jurisdiction; readers should ascertain whether or not it can be used.

LIFO retail method.

As with other LIFO concepts, tax regulations are the governing force behind the LIFO retail method. Readers must ascertain whether regulations in their local jurisdictions permit application of this or any similar method.

The steps used in computing the value of ending inventory under the LIFO retail method are listed below and then applied to an example for illustrative purposes.

  1. Calculate (or select) the current year conversion price index. Recall that in the base year this index will be 1.00.

  2. Calculate the value of the ending inventory at both cost and retail. Remember, as with other LIFO methods, tax regulations do not permit the use of LCM, so both markups and markdowns are included in computation of the cost-to-retail ratio. However, the beginning inventory is excluded from goods available for sale at cost and at retail.

  3. Restate the ending inventory at retail to base-year retail. This is accomplished by dividing the current ending inventory at retail by the current year index determined in step 1.

  4. Layers are then treated in the same fashion as they were for the dollar-value LIFO example presented earlier. If the ending inventory restated to base-year retail exceeds the previous year's amount at base-year retail, a new layer is established.

  5. The computation of LIFO cost is the last step and requires multiplying each layer at base-year retail by the appropriate price index and multiplying this product by the cost-to-retail ratio in order to arrive at the LIFO cost for each layer.

The following example illustrates a two-year period to which the LIFO retail method is applied. The first period represents the first year of operations for the organization, and thus, is its base year.

Year 1

  • Step 1—Because this is the base year, there is no need to compute an index, as it will always be 1.00.

  • Step 2—

    Cost

    Retail

    Beginning inventory

    $ --

    $ --

    Purchases

    582,400

    988,600

    Markups

    --

    164,400

    Markdowns

    --

    (113,000)

    • Subtotal

    $582,400

    $1,040,000

    Total goods available for sale

    $1,040,000

    Sales at retail

    840,000

    Ending year 1 inventory at retail

    $ 200,000

    Cost-to-retail index 582,400/1.040,000

    = 56%

    Ending inventory at cost $200,000 x 0.56

    $112,000

  • Step 3—Because this is the base year, the restatement to base-year cost is not necessary; however, the computation would be

    • $200,000/1.00 = $200,000.

  • Steps 4

    • and 5—The determination of layers is again unnecessary in the base year; however, the computation would take the following format.

      Ending inventory at base-year retail

      Conversion price index

      Cost-to retail ratio

      LIFO cost

      Base year ($200,000/1.00)

      $200,000

      1.00

      0.56

      $112,000

Year 2

  • Step 1—The assumption is made that the computation of an internal index yields a result of 1.12 (obtained by double-extending a representative sample).

  • Step 2—

    Cost

    Retail

    Beginning inventory

    $112,000

    $ 200,000

    Purchases

    716,300

    1,168,500

    Markups

    --

    87,500

    Markdowns

    --

    (21,000)

    • Subtotal

    $716,300

    $1,235,000

    Total goods available for sale

    $1,435,000

    Sales at retail

    1,171,800

    Ending year 2 inventory at retail

    $ 263,200

      • Cost-to-retail index 716,300/1,235,000 = 58%

  • Step 3—The restatement of ending inventory at current year retail to base-year retail is done using the index computed in step 1. In this case it is $263,200/1.12 = $235,000.

  • Steps 4

    • and 5—We know that there is a LIFO layer in year 2 because the $235,000 inventory at base-year retail exceeds the year 1 amount of $200,000.

      • The computation of the LIFO cost for each layer is shown below.

    Ending inventory at base-year retail

    Conversion price index

    Cost-to-retail ratio

    LIFO cost

    Base year ($200,000/1.00)

    $200,000

    1.00

    0.56

    $112,000

    Year 2 layer

    35,000

    1.12

    0.58

    22,736

    $235,000

    Ending year 2 inventory at LIFO cost

    $134,736

The treatment of subsequent increments and decrements is the same for this method as it is for the regular dollar-value method.

Gross profit method.

The gross profit method is used to estimate ending inventory when a physical count is not possible or feasible. It can also be used to evaluate the reasonableness of a given inventory amount. The cost of goods available for sale is compared with the estimated cost of goods sold. For example, assume the following data:

Beginning inventory

$125,000

Net purchases

450,000

Sales

600,000

Estimated gross profit

32%

Ending inventory is then estimated as follows:

Beginning inventory

$125,000

Net purchases

450,000

Cost of goods available for sale

575,000

Cost of goods sold [$600,000 - (32% x $600,000)] or (68% x $600,000)

408,000

Estimated ending inventory

$167,000

The gross profit method is used for interim reporting estimates, analyses by auditors, and estimates of inventory lost in fires or other catastrophes. The method is generally not acceptable for either tax or annual financial reporting purposes (and is not in conformity with IAS 2). Thus, its major purposes are for internal and interim reporting.

Other Cost Topics

Base stock.

The base stock method assumes that a certain level of inventory investment is necessary for normal business activities and is therefore permanent. The base stock inventory is carried at historical cost. Decreases in the base stock are considered temporary and are charged to cost of goods sold at replacement cost. Increases are carried at current year costs. The base stock approach is seldom used in practice and it is not allowed for tax purposes in many jurisdictions, and the LIFO method, which is more commonly permitted, gives similar results. Although the original IAS 2 permitted the base stock method, it has been proscribed since revised IAS 2 became effective in 1995.

Standard costs.

Standard costs are predetermined unit costs used by many manufacturing firms for planning and control purposes. Standard costs are often incorporated into the accounts, and materials, work in process, and finished goods inventories are all carried on this basis of accounting. The use of standard costs in financial reporting is acceptable if adjustments are made periodically to reflect current conditions and if its use approximates one of the recognized cost flow assumptions.

Purchase commitments.

Purchase commitments generally are not recorded in the accounts because they are executory in nature. However, footnote disclosure is required for firm purchase commitments that are material in amount in accordance with IAS 37.

Furthermore, and in conformity with the same standard, if losses have been incurred in connection with firm purchase commitments, the losses must be accrued if probable and reasonably estimable. Note that this results in recognition of loss before the asset is recognized on the books. Contingencies are discussed in detail in Chapter 12.

Inventories valued at selling price.

In exceptional cases, inventories may be reported at sales price less disposal costs. Such treatment is justified when cost is difficult to determine, quoted market prices are available, marketability is assured, and units are interchangeable. IAS 2 stipulates that producers' inventories of livestock, agricultural and forest products, and mineral ores, to the extent that they are measured at net realizable value in accordance with well-established practices, are to be valued in this manner. When inventory is valued above cost, revenue is recognized before the point of sale; full disclosure in the financial statements would, of course, be required.

Use of more than one cost method.

IAS 2 did not address the question of whether a single reporting entity would be justified in using a multiplicity of costing methods for different components of its inventory. In practice, many reporting enterprises have used different methods; for example, the uses of LIFO for raw materials and FIFO for work in process and finished goods inventories are fairly common. In other cases, conglomerate entities have certain operations or divisions that use one method, and others that employ alternative costing formulae.

While the issue was not raised, logic suggests that if a variety of costing methods were employed for essentially similar inventories by a single entity, it would make an understanding of the resulting financial statements more difficult for users. Accordingly, the Standing Interpretations Committee (SIC) of the IASC addressed this matter. In reaching its conclusion that similar inventories must be costed by the same method, it weighed the guidance already contained in IAS 27 (on consolidated financial reporting) and IAS 16 (on property, plant, and equipment).

The existing standard on consolidations provides that uniform accounting policies are to be used for like transactions and other events in similar circumstances. The logic is to avoid adding apples and oranges to develop consolidated financial statements that are unintelligible as a consequence. The IASC's Framework for the Preparation and Presentation of Financial Statements similarly expresses the notion that measurement of like transactions and other events should be carried out in a consistent manner throughout an entity and over the time of its ongoing existence, for purposes of both separate and consolidated financial reporting.

IAS 16 permits the use of different methods of measurement for different classes of property and equipment. Thus, for example, buildings might be depreciated by the straightline method, and equipment may be depreciated using an accelerated method; it can be justified based on patterns of usage and other factors, such as likely incidence of repair and maintenance costs. However, the use of different methods for similar assets in similar modes of use would not be consistent with IAS.

Taking these matters into account, the logical conclusion would be that inventories used in similar fashion by a given entity, even differently sited or managed operations of a given enterprise, should be costed by the same formula or method. The first interpretative release by the IASC's Standing Interpretations Committee has endorsed this position. In SIC 1, it has held that, regarding the possible use of different cost formulae (e.g., LIFO versus FIFO) for different types of inventories, for inventories having different natures and uses, differing cost formulae could be justified. It was noted, however, that differences in geographical locations are not sufficient to warrant using different costing methods. Inventories having the same characteristics should, on the other hand, be valued by means of the same cost formulae. Disclosure should be made of the accounting methods used in any event.

Disclosure Requirements

IAS 2 sets forth certain disclosure requirements relative to inventory accounting methods employed by the entity preparing the financial statements. According to this standard, the following must be disclosed:

  1. The accounting policies adopted in measuring inventories, including the costing methods (e.g., FIFO, weighted-average, or LIFO) employed

  2. The total carrying amount of inventories and the carrying amount in classifications appropriate to the enterprise

  3. The carrying amount of inventories carried at net realizable value

  4. The amount of any reversal of any previous write-down that is recognized in earnings for the period

  5. The circumstances or events that led to the reversal of a write-down of inventories to net realizable value

  6. The carrying amount of inventories pledged as security for liabilities

The type of information to be provided concerning inventories held in different classifications is somewhat flexible, but traditional classifications, such as raw materials, work in progress, finished goods, and supplies, should normally be employed. In the case of service providers, inventories (which are really akin to unbilled receivables) can be described as work in progress.

When the cost of inventories is determined in accordance with the LIFO method, which is an available alternative under IAS 2, the financial statements must disclose the difference between the amount of inventories shown on the balance sheet and either (1) the cost determined in accordance with either the FIFO or weighted-average costing methods, subject to the net realizable value rule, or (2) the lower of current (i.e., replacement) cost as of the balance sheet date or net realizable value.

In addition to the foregoing, the financial statements should disclose either the cost of inventories recognized as an expense during the period (i.e., reported as cost of sales or included in other expense categories), or the operating costs, applicable to revenues, recognized as an expense during the period, categorized by their respective natures.

Costs of inventories recognized as expense includes, in addition to the costs inventoried previously and attaching to goods sold currently, the excess overhead costs charged to expense for the period because, under the standard, they could not be deferred to future periods.




Wiley Ias 2003(c) Interpretation and Application of International Accounting Standards
WILEY IAS 2003: Interpretation and Application of International Accounting Standards
ISBN: 0471227366
EAN: 2147483647
Year: 2005
Pages: 147

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