Intermediate
Financial Accounting I
Inventories: Measurement
Objectives of this Chapter
1. Discuss the importance of inventory
valuation.
2. Study perpetual and periodic inventory
systems and the ending period
adjustments for inventory.
3. Study and compare the inventory cost
flow assumptions.
4. Explain the effect of LIFO liquidations.
Inventories: Measurement
2
Objectives of this Chapter (contd.)
5. Identify the items that should be
included in the inventory count.
6. Discuss the lower of cost or market
(LCM) rule.
7. Study the accounting treatment of
changing to LIFO cost flow assumption
and the use of LIFO reserve account.
8. LIFO Inventory Pools
9. Dollar-value LIFO technique.
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3
1. Inventories:
the Importance of Inventory Valuation

How would the valuation and cost flow
assumptions of inventory affect the income
measurement?
Valuation Methods: Historical Cost,
Current Exist Value, Current Entry Value,
Present Value, LCM.
 Cost Flow Assumptions: LIFO, FIFO,
Average, Specific Identification.
 CGS = Beginning Inventory + Net
Purchase - Ending Inventory

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4
Inventories:
the Importance of Inventory Valuation (contd.)

Different valuation methods and
different cost flow assumptions will
result in different cost of ending
inventories and therefore different cost
of goods sold.
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5
The Impact of Valuation of Ending
Inventory on The CGS & Income
Year 1
Income CGS = Beg. Inv. + Net Pur. - End. Inv.
under
over
under a
over
under
over b
Year 2
over
under
under
over
under
over
a. either understating the units or the value
b. either overstating the units or the value
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6
Impact on Omitting Goods from
Purchases
CGS = Beg. Inventory + N.P. - End. Inventory
B/S
Ending Inv.
understated
R/E
no effect
A/P
under
Working Capital no effect
Current Ratio overstatinga
I/S
Purchase
understated
CGS
no effect
N/I
no effect
Inventory (End.) understated
a. When CA > CL
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7
Defining Inventory
1. Assets held for resale purpose in a
normal course of business
2. Assets used to produce products for
resale purpose
 Merchandising
Firms: Merchandise
 Manufacturing Firms: Raw materials
Work-in-process
Finished Goods
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8
How to Determine Inventory Value
Presented on the Balance Sheet?


Applying either the periodic inventory
system or the perpetual inventory
system and select a cost flow
assumption to determine the value of
inventories.
Both inventory systems require a
physical count of inventory at the end of
a period to determine the units which
can be included in the inventory account.
Inventories: Measurement
9
2. Inventory Systems and
Ending Period Adjustments

Types of Inventory Systems

A. Perpetual Inventory System

B. Periodic Inventory System
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10
A. Perpetual Inventory System


Purchase:
Inventory
A/P
xxx
CGS
xxx
xxx
Sale:
Inventory
A/R
xxx
xxx
Sales
xxx
Inventories: Measurement
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Perpetual Inventory System (contd.)



Inventory account is used for the
purchase and sale transactions.
CGS account is used to record the CGS
of a sale. Therefore, the CGS is also
known at all time.
CGS is determined by selecting a cost
flow assumption.
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Perpetual Inventory System
Example
Date
Purchase Sell
3/1 (Beg. Bal.)
3/5
150 $6
3/7
3/14
3/28
200
a
100 $7
30b
Balance
FIFO
LIFO
100 $5
100 $5
150 $6
50 $6
50 $6
100 $7
20 $6
100 $7
W-A
100 $5
100 $5
100 $5
250 $5.6
150 $6
50 $5
50 $5.6
50 $5
150 $6.53
100 $7
50 $5
120 $6.53
70 $7
a. Sales price is $10 per unit.
b. Sales price is $11 per unit.
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Example (contd.) - Journal Entries
(Perpetual vs. Periodic)
Perpetual (FIFO)
3/5 Inventory 900
Cash
900
3/7 Cash
2,000
Sales Rev. 2,000
CGS
1,100
Inventory 1,100
3/14 Inventory 700
Cash
700
3/28 Cash
330
Sales Rev.
330
CGS
180
Inventory
180
Periodic
3/5 Purchases
900
Cash
900
3/7 Cash
2,000
Sales Rev. 2,000
3/14 Purchases 700
Cash
700
Cash
330
Sales Rev.
330
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Perpetual Inventory System
Example (contd.)
Inventory a
(FIFO)
B.B.500 1100
900 180
700
E.B.820
Inventory
(LIFO)
500 1150
900
210
700
740
Inventory
(WA)
500
1120
900
195.9
700
784.1
a. The balance of inventory is known at all time
under the perpetual inventory system.
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Perpetual Inventory System
Example (contd.)
The balance of cost of goods sold account1 :
CGS
(FIFO)
3/7...1100
3/28...180
1280
CGS
(LIFO)
1150
210
1360
CGS
(W-A)
1120
195.9
1315.9
1.The balance of inventory is known at all time
under the perpetual inventory system.
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Ending Period Adjustments
Perpetual Inventory System
a. Adjustments for lost units.
b. Adjustments for LCM valuation.
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a. Adjustments for Lost Units
(Perpetual Inventory System)
Assuming ending units = 110 units.
On 3/31, the lost units = 10.
Cost of 10 lost units => $6 x 10 = $60 (FIFO)
$7 x 10 = $70 (LIFO)
$6.53 x 10 = 65.3 (W-A)
Adjusting Entry:
3/31 Loss on Inventory Units a
Inventory
60
60
a. or use the account of Inventory over and short
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b. Adjustments for LCM Valuation
(Perpetual Inventory System)
Inventory (FIFO)
B.B 500
1,100
900
180
700
820
60 -- 3/31 (Adj. for lost units)
760
Ending Inv. Cost (on 3/31, FIFO)
= $760
Assuming market price = $600 LCM = $600
Inventories: Measurement
LCM
=$600
19
Adjustments for LCM Valuation
(contd.)

Adjusting entry => Given that Allowance for
Declining in Market Value of inventory has a
beginning balance of zero:
Allowance
0 -- 3/1
160
160 -- 3/31
B/S (3/31)
Inventory
Allowance
Inv. At LCM
3/31
Loss Due to Market Value
Decline of Inventory
160
Allowance to Reduce
Inventory to Market 160
760
(160)
600
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An Alternative of LCM Adjustment
 Many companies (i.e., Cisco Systems, inc.
2001, source: Spiceland, etc.)record the
adjustment of LCM follows:
 Cost of Goods Sold
160

Inventory
160
 Note: Recording the loss as an increase in CGS will
have the same impact on earnings as reporting it as a
loss from value decline in the holding inventory.
However, this treatment will distort the gross profit.
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Adjustments for LCM Valuation
(contd.)

If the allowance account had a beginning
balance of $20, the adjusting entry would
be:
Allowance
20 -- 3/1
Loss
140
140
Allowance
140
160 -- 3/31
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Adjustments for LCM Valuation
(contd.)

If the Allowance account had a
beginning balance of 200, the adjusting
entry would be:
Allowance
40 200
160
Allowance
40
Gain from Recovery
of M.V. of Inventory
40
Inventories: Measurement
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B. Periodic Inventory System

At the end of an accounting period, the
following steps must be followed to
determine the cost of ending inventory
and cost of goods sold:
1. Do an inventory count.
2. Applying a cost flow assumption to
determine the cost of ending inventory.
3. Determine the cost of goods sold using:
CGS = Beg. Inv. + Net Pur. - Ending Inv.a
a. No adjusting entries are required.
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Example

Periodic Inventory Systema
Using the example on Page 10 and
assuming the physical count of
inventory indicates 105 units on hand
on 3/31, the cost of ending inventory
(105 units) would be (given a FIFO
cost flow assumption):
$7  100 + $6  5 = $730
a. For journal entries, see page 14.
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Example (contd.)
Inventory Data:
Units
3/1 (B.B) 100
3/5 Pur. 150
3/14 Pur. 100
Periodic Inventory System
The CGS under FIFO is:
Cost $500 + 1,600 - 730 =
$1,370.
$5
$6
If a LIFO assumption is
used, the cost of end.
$7
Inv. is:
$5 x 100 + $6 x 5 = $530.
The CGS is:
$500 + 1600 - 530 =
$1,570.
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Ending Period Adjustments
(Periodic Inventory System)
1. No adjustment is needed for lost units
(because the cost of lost units is
embedded in the CGS).
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Ending Period Adjustments
(Periodic Inventory System)
2.Adjustment for the LCM valuation assuming
FIFO:
Cost of E.I. = $730
Market
= $600
3/1(assumed)
LCM
= $600
Allowance
0 -130
130 --3/31
Adjusting entry:
Loss Due to Market Decline of Inv.
Allowance to Reduce Inv. to Market
Inventories: Measurement
130
130
28
3. Comparison of FIFO vs. LIFO
During an Inflation Period
Income
Tax
B/S
I/S
LIFO
(matching
current cost
with revenue
if not
depleted to
early layers)
Low
Low
Unfair
Fair
FIFO
High
High
Fair
Unfair
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Survey: (Source: Accounting Trends &
Techniques) a, b,c
Yearl
1984
Firms
1061
100%
1038
100%
LIF1O
408
38%
379
36.5%
FIFO
366
30%
396
38%
W-A
225
22%
213
20.5%
1991
1032
100%
361
35%
421
41%
200
19%
50
5%
2000
887
100%
283
32%
386
44%
180
20%
38
4%
2006
802
100%
228
28%
385
48%
159
20%
30
4%
2010
666d
100%
176
325
147
26.4% Inventories:
49%Measurement
22%
1988
Others
52
5%
50
5%
18
2.6%
30
Survey: (Source: Accounting Trends &
Techniques) (contd.)
c.
Sample firms are 600 firms. Most companies
adopt more than one inventory method.
Due to low inflation, the number of firms
adopting LIFO has declined since mid-1980s.
IAS No. 2 does not permit LIFO, and
therefore, multinational companies use LIFO
for all or most of their domestic inventories
while use FIFO or average cost for their
foreign subsidiaries.
d.
The number of disclosures.
a.
b.
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Switching to LIFO
During an Inflation Period

Reason of switching to LIFO:
Tax savings.
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Income Manipulation When LIFO Is
Used (assuming price is rising)
1. To increase income (by decreasing
CGS):
Strategy:
2.To decrease income (by increasing
CGS):

Strategy:
Inventories: Measurement
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Advantages of FIFO
a. Less likely to be subject to
management manipulation;
b. Produce higher income during an
inflation period;
c. Inventory cost reported on the B/S is
close to the replacement cost.
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Disadvantage of FIFO
a. Bad matches of sales revenue and
CGS; match current sales revenue with
old costs;
b. Producing higher income during an
inflation period results in paying more
income tax.
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Advantages of LIFO
a. Good match of sales revenue with
CGS.
b. Produce lower income during an
inflation period; result in tax savings.
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Disadvantages of LIFO
a. Inventory cost presented on the B/S is
not fair.
b. Subject to management manipulation.
Note: International Accounting Standard
No. 2 does not allow LIFO.
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IRS
1. Does not allow firms to use LCM if
firms are using LIFO.
2. LIFO conformity rule.
The non-LIFO income numbers are
allowed on the supplementary reports
since 1981.
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IRS (contd.)
3. LIFO is not acceptable by the IRS till
1939.
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4. LIFO Liquidations

A LIFO Liquidation profit can occur
when units purchased are less than
units sold in the period.
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An Example of LIFO Liquidation
Profit
20x5 Beg. Inv.
Pur.
Pur.
Pur.
400
300
500
600
$5
$6
$7
$8
During 20x5, 1,700 units were sold.
What is the LIFO liquidation profit?
Total purchases of 20x5 are 1,400 units.
The LIFO liquidationprofit is:
(1,700-1,400) x ($8-$5) = $900
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Choice of Inventory Cost-Flow Assumptions and
Conversion of FIFO to LIFO for Comparison
Purposes
a. Choice of inventory cost-flow
assumptions.
b. Inventory Management (JIT system,
Inventory turnover rate, etc.): the
example of Dell Inc.
c. Adjustment of inventory cost-flow
assumption on the same basis before
making comparison of financial
statements.
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Adjustment of Inventory Cost-Flow
Assumption – An Example
Information: ABC is currently adopting
FIFO assumption. IF LIFO were
adopted, cost of ending inventory
would be $1,000 and $3,000 lower for
x1 and x2, respectively.
Question: How much would the CGS and
income be different when LIFO is
adopted rather than FIFO?
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Adjustment of Inventory Cost-Flow
Assumption- An Example (contd.)
CGS = Beg. Inv. + Net Pur. – End. Inv.
Impact => -1000
-3000
of LIFO
(LIFO Reserve)
Thus, CGS should be increased by
$2,000 and income before tax would be
decreased by $2,000.
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LIFO Reserve: An Account Used to Adjust
Ending Inventory Value from FIFO to LIFO


The difference in the value of inventory
between the inventory method used for
internal reporting purposes (i.e., FIFO)
and LIFO is referred to as LIFO
Reserve or the Allowance to Reduce
Inventory to LIFO .
The change in the balance of LIFO
Reserve from one period to another is
referred as the LIFO Effect (i.e.,impact
on income).
Inventories: Measurement
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LIFO Reserve - Example



Assume Acme Boot Company uses the
FIFO method for internal reporting
purposes and LIFO for external reporting
purposes. On 12/31/x5, the LIFO Reserve
balance was $20,000. However, the value
of ending inventory on 12/31/x6 under
LIFO is $50,000 less than that of FIFO.
Inventory on 12/31/x5 at FIFO = $320,000
Inventory on 12/31/x6 at FIFO =$360,000
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LIFO Reserve – Example (contd.)
(Inventory Disclosure, note D)12/31/x6



12/31/x5
Inventory at FIFO $360,000 $320,000
LIFO Reserve
(50,000)
(20,000)
Inventory at LIFO $310,000 $300,000


Thus, $30,000 should be added to the
LIFO Reserve account. The LIFO effect
(impact on income) for 20x6 is $30,000.
Inventories: Measurement
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LIFO Reserve - Example (contd.)
J.E. to adjust inventory from FIFO to LIFO:
Cost of Goods Sold
30,000
LIFO Reserve a
(or Allowance to Reduce
Inventory to LIFO)
30,000
a. reported as a contra account to inventory
or a deduction from inventory
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Inventory Presentation and Footnote
Disclosure
Inventories, net of adjustment to
LIFO Reserve
(Note D)
$310,000
Note D (contd.): Inventories. Inventories
are valued at the lower of cost or
market determined principally by the
LIFO method. If the FIFO cost method
had been used, inventories would have
been $50,000 higher.
Inventories: Measurement
49
5. Items to Be Included in Inventory

Any goods with the legal title transferred
to the buyer should be included in the
inventory of the buyer (including goods
in transit with a F.O.B. shipping point
term).
Inventories: Measurement
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Special Cases
a. Consigned Goods: Legal title
remained with the consignor
(manufacturers).
b. Sales with High Sales Returns
(conditional sale):
c. Sales on Approval:
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Special Cases (contd.)
d. Product Financing Arrangements:
(Parking Transactions; SFAS No. 49)
e. Sales on Installment (revenue
recognition on accrual basis):
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What Should Be Included in The
Product Costs
 --> Yes
 Purchase price
x --> No
 --> may be
 Freight-In cost
x Handling charge
x Storage cost related to purchase
x Buying cost of the purchasing department
x Insurance, taxes
 Interest cost: only in some cases.
Inventories: Measurement
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What Should Be Included in the
Product Costs (contd.)

Purchase Discount account should be
treated as a contra account to
purchases.
Inventories: Measurement
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6. Inventory Valuation - the LCM Rule
Departure from Historical Cost Assumption
LCM: Lower of Cost or Market.
Reasons: Conservatism.
Market ==> Replacement Cost constrained by:
Ceiling => Net Realizable Value
= Selling price - estimated cost to
complete and sell
Floor => NRV - normal profits
Inventories: Measurement
55
Inventory Valuation - Example
 Selling price = 12
 Package cost = $1
 Transportation cost = $3
 Normal profits = $3
 NRV = Selling price - Package -
Transportation = $12 - $1- $3 = $8
 NRV - Normal profit = $5
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Inventory Valuation - Example (contd.)
Acquisition Replacement
NRV NRV
Market LCM
Cost
Cost
Profit
$10
a
$10
b
$10
$10
$6
$9
$4
$12
$8
$8
$8
$8
$5
$5
$5
$5
$6
$8
$5
$8
$6
$8
$5
$8
a. Example of the ceiling can prevent future
unexpected loss.
b.Example of preventing the recognition of
abnormal loss in the current period.
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57
Inventory Valuation - LCM



For financial reporting, LCM can be
performed at the individual item level, at the
category level or at the total inventory level.
Common practice: at the individual item
level.
LCM performed at the individual item level is
most conservative and is most commonly
used because it is complied with the IRS
rule.
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58
LCM Application - at Individual Level
versus at Group Level
Item
A
B*
C
Total
Cost
$50
$140
$300
$490
_____
_____
Market LCM (at individual level)
$60
$50
$100
$100
$360
$300
$520
$450
_____
_____
_____
_____
LCM at group level ==> $490
The difference of $40 is resulting from item
B: $140 - 100 = $40
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59
LCM and iGAAP




IAS No. 2 requires inventory to be valued
at LCM.
The market value of IAS is the NRV, not
the replacement cost as in US GAAP.
IAS allows the reversal of inventory writedown when the conditions for write-down
do not exist.
US GAAP does not allow the reversal of
inventory write-down.
Inventories: Measurement
60
7. Initial Adoption of LIFO



The accounting treatments for
accounting method changes are:
a. Current Period Approach: cumulative
effect from the change reported in the
I/S. (Note: eliminated by SFAS 154)
b. Retrospective Approach
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61
Initial Adoption of LIFO


When change from other method to
LIFO, neither a cumulative effect nor a
retrospective adjustment can be made.
The base year inventory for all following
years is the beginning inventory of the
year In which LIFO is adopted.
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62
Initial Adoption of LIFO


This value of the beginning inventory
needs to be adjusted to the cost.
The effect of the change on the current
year’s income and on the value of the
ending inventory must be disclosed.
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63
Journal Entry to Restate
the Beginning Inventory to Cost

Assume that Rooms, Inc. decided to
switch from FIFO to LIFO in 20x9.
The beginning inventory of 20x9 has a
cost basis of $100,000 but is reported
at $90,000 on the balance sheet
because market is lower than cost.
The following entry is made to restate
the inventory to a cost basis (ignoring
tax effects):
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64
Journal Entry to Restate the
Beginning Inventory to Cost (contd.)

Alternative 1:
Allowance to Reduce
Inventory to Market
10,000
Adjustment to Record
Inventory at cost
10,000
(If an allowance method is used in LCM
application.)
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65
Journal Entry to Restate the
Beginning Inventory to Cost (contd.)

Alternative 2:
Inventory
10,000
Adjustment to
Record Inv. at Cost
10,000
(only If a direct write-off method is used in
LCM application)
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66
Footnote Disclosure of Changing
from FIFO to LIFO
Note: Inventory Pricing. In the fourth quarter, the
company expanded its use of the LIFO method
of inventory to additional portion of its
inventories in order to more closely match
current costs with current revenues. The effect
of this change was to reduce net income for the
current year by $2,804,000 or $0.49 per share.
As of December 31, inventories valued on a
LIFO basis amounted to $74,166,000. If valued
on a FIFO basis, such inventories would be
increased to $90,551,000.
Inventories: Measurement
67
8. LIFO Inventory Pools (Specific Goods
Pooled LIFO) (source: Spiceland, etc.)*
 Problems associated with the Unit LIFO
(i.e., the LIFO concept applies to units of inventory
as described in previous sections; also called
specific goods LIFO):

Costly to implement: It requires the
records of each unit of inventory.

LIFO liquidations: When units of a
specific inventory purchased are less
than units sold during the period, the
beginning layers are eroded.
Inventories: Measurement
68
LIFO Inventory Pools (contd.)*



LIFO inventory pools technique can:
1) simplify recordkeeping by grouping
inventory into pools, and
2)reduce the probability of LIFO layer
liquidation/erosion.
Inventories: Measurement
69
LIFO Inventory Pools (contd.)


Within pools, all purchases of goods in the
pool are considered to be made at the
same time during the period and at the
average cost.
When the quantity of ending inventory in
the pool increases (i.e., the quantity of
ending inv. is greater than that of the beg.
Inv.), the ending inventory of the pool will
consist of the beg. Inv. and the layer of the
period.
Inventories: Measurement
70
LIFO Inventory Pools: An Example
(contd.)

The 2008 beg. inventory (BI)of Cole Glass Inc.
LIFO inventory pool consisted of the following:
Quantity (squared
foot (SF))
Cost (per
SF)
Total Cost
Grade A Window 10,000
Glass
$3.00
$30,000
Grade B
14,000
$2.50
$35,000
Grade C
11,000
$2.20
$24,200
Totals
35,000
Average SF Cost $2.55 =
of the Pool -BI
$89,200
($89,200/
35,000)
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71
LIFO Inventory Pools: An Example

During 20x8, Cole sold 48,000 squared feet of
window glass and purchased 51,000 squared
feet as follows:
Quantity (squared
foot (SF))
Cost (per SF)
Total Cost
Grade A Window
Glass
20,000
$3.10
$62,000
Grade B
15,000
$2.60
$39,000
Grade C
16,000
$2.45
$39,200
Totals
51,000
Average 2008 SF
Cost of the Pool
$2.75 =
$140,200
($140,200/
51,000)
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72
LIFO Inventory Pools: An Example
(contd.)


The average cost of 2008 beg. inventory
and 2008 window glass inventory pool is
$2.55 and $2.75, respectively.
The ending inventory quantity for the
pool is:
35,000+51,000-48,000=38,000 units
Inventories: Measurement
73
LIFO Inventory Pools: An Example
(contd.)


Since the ending inventory of 2008
exceeds its beg. Inventory, the ending
inventory will include the beginning
inventory (i.e., 35,000 units ) and a LIFO
layer of 3,000 units from 2008 .
Thus, the cost of 2008 ending inventory
equals:
$2.55 x 35,000+ $2.75x 3,000 = $97,500
Inventories: Measurement
74
Problems Associated with LIFO
Inventory Pools



When a product in an inventory pool is
discontinued, the old costs of the discontinued
item will become the cost of goods sold and
therefore, result in LIFO liquidation.
Even if the product is replaced, it may not be
similar to the old item and cannot be included
in the same pool.
Therefore, LIFO inventory pool requires
redefine pools periodically when there are
changes in the product mix of the pool.
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75
9. Dollar-Value LIFO (DV LIFO)
Technique*


DV LIFO technique simplifies the
recordkeeping procedures (due to no
need to keep unit flows).
DV LIFO technique helps to protect
LIFO layers from erosion (i.e., reduce the
probability of LIFO liquidations; more than
the LIFO inventory pool technique).

This technique is frequently used in
practice
Inventories: Measurement
76
DV LIFO Technique (contd.)*



DV LIFO defines a layer as the dollar
value, not units, of ending inventory for a
specific year.
One layer is formed for each year.
Dollar Value of Inventories: Current cost
(the most recent purchase price) of the
ending Inventory.
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77
DV LIFO Technique (contd.)*


To determine whether a new LIFO layer
is added under DV LIFO, the DV of
ending inventory (EI) is compared with
that of the beg. Inventory (BI).
If the DV of EI exceeds that of the BI,
the EI layers will consist of the DV of
the BI layer plus a new DV layer
created for the current year (i.e., the DV
of EI – the DV of BI).
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78
The Cost Index


When the price level of the EI differs from
that of BI, a cost index should be used to
adjust the DV of EI at the price level of the BI
before forming the layers for the EI.
Cost index of a layer year =
Cost in layer year/Cost in base year
 Base year is the year in which DV LIFO is
adopted and a layer year is any subsequent
year in which an inv. Layer is created..
Inventories: Measurement
79
Dollar Value LIFO – An Example
Layer Current Cost Cost
Year
20x0 a
20x1
20x2
20x3
EI at
of Ending (Price) Base year
Inventory Index Price Levl.
$20,000
100
$20,000
$30,000
120
$25,000
$31,200
130
$24,000
$39,200
140
$28,000
Value of
Inv. At
D-V LIFO
$20,000
$26,000
$24,800
$30,400
a. the base year
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80
Example (contd.)
Forming of layers:
20x0
20x1
20x2
20x3
20,000 ... L1 20,000...L1 20,000...L1 20,000...L1
5,000...L2 4,000...L2 4,000...L2
0...L3
0...L3
4,000 ..L4
Converting to the corresponding year’s index level:
20x0
20x1
20x2
20x3
20,000x1
=20,000
20, 000x1+ 20,000x1+ 20,000x1+
5 ,000x1.2 4,000x1.2+ 4,000x1.2+
=26,000
0x1.3
0x1.3+
=24,800 4,000x1.481
Inventories: Measurement
Comments on Dollar-Value LIFO


Items with similar economic, not
physical, characteristics (i.e., subject to
similar cost change pressure) will be
pooled together.
The more items are included in an
inventory pool, the less likely the
erosion of the LIFO layers can occur.
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82
Comments on Dollar-Value LIFO
(contd.)*


Income number can be manipulated by
changing the number of inventory
pools.
On average, retailers form 6 pools for
their inventories and non-retailers form
3 pools for their inventories.
Inventories: Measurement
83
An Example of Manipulating Income by
Changing the Number of Inventory Pools

Stauffer Chemical Company had
increased LIFO pools from 8 to 280 ,
boosting its net income by $16,515,000
(13%) (source: KWW, 13th edition).
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84
Types of Indexes




Internal Index: Internal price index
computed by the company for its own
product.
External Index: Computed by an outside
party such as the government, commodity
exchange, or trade association.
General Index: Composed of several
commodities, goods or services.
Specific Index: For one commodity, good
or service.
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85
External Price Index*

The Consumer Price Index for urban
consumers (CPI-U) is an example of an
external general price index.

CPI-U is published monthly by the Bureau of
Labor Statistics of the federal government.

Specific external price indexes (i.e., for gold,
silver, corn…) are also available from trade
associations.
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86
The Internal Indexes
A Double-Extension Method (i.e., the value
of inv. units extended at both current and base-year
prices):
Internal Index for the Current Year =
End. Inv*. at Current Year’s Cost
End. Inv. at Base-Year Cost
End. Inv. is the ending inventory of the
current year.
The cost index for the base year equals one.
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87
Example

To compute specific internal price indexes:
Year
20x0 (base year)
20x1
20x2
20x3
Current Units of
Cost End. Inv.
$19
300
$22.8
400
$24.7
450
$26.6
370
Cost
Index(%)
100a
120b
130c
140d
a. 19*300/19.0*300=100% c.24.7*450/19*450=130%
b. 22.8*400/19*400=120% d.26.6*370/19*370=140%
Inventories: Measurement
88
Example (contd.)

General internal price index:
(for more than one inventory in the pool):
Inv. A
Inv. B
Current Units of Current Units of
Cost End. Inv. Cost End. Inv.
20x0(base year) $19
100
$20
150
20x1
$22.8 110
$22
120
General internal price index of 20x0:
(19x100+20x150) / (19x100+20x150)=100%
General internal price index of 20x1:
(22.8x110+22x120) / (19x110+20x120)=114.6%
Inventories: Measurement
89