Goods to be incorporated into a product or used in the production process that have not yet entered the process are referred to as raw materials inventory. The output from one process can become the raw material for another process (e.g., subassemblies).

Goods typically are classified as work in process inventory as soon as they are drawn from raw materials stock and enter the manufacturing process.

Products that are complete and ready for sale are considered finished goods inventory.

Materials necessary for the manufacturing operation but not a significant component of the final product are known as supplies inventory. For example, small incidental screws may be considered supplies inventory, or oil used to lubricate a grinding machine may be considered supplies inventory. The ARB No. 43 specifically mentions manufacturing supplies as a type of inventory and notes that the fact that a small portion of the supplies may be used for purposes other than production does not require separate classification.

Many other types of products may be classified as inventory for financial reporting purposes. Examples include by-products (secondary products that result from the manufacturing process, particularly in the chemicals and the oil and gas industries), reusable items (such as beverage containers), and extractive products.

Written instructions that describe the procedures to be performed by the individuals participating in the count are an important part of the effort and should be prepared and distributed well in advance of the physical inventory date.

The instructions should cover each phase of the procedures and address these 11 matters:

Physical inventory count teams should be familiar with the inventory items. The counts should be checked, or recounts should be performed, by persons other than those making the original counts.

The process to ensure that transactions are recorded in the proper accounting period is known as cutoff. For inventory, the general rule is that all items owned by the entity as of the inventory date should be included, regardless of location. For goods in transit, if they are shipped free on board (fob) destination, ownership does not pass from the seller to the purchaser until the purchaser receives the goods from the common carrier. For goods shipped fob shipping point, title passes from the seller to the purchaser once the seller turns the goods over to the common carrier.

In practice, purchases are recorded upon receipt, based on the date indicated on the receiving report. Inventory generally is relieved for items sold as of the date of shipment. In this manner, the accounting entries to record the purchase and sale of inventory correspond to the physical movement of the goods at the company. Assuming an accurate physical count of goods on hand is achieved, companies effectively eliminate cutoff errors by verifying that purchases have been recorded in the period of receipt and sales have been recorded in the period of shipment. This usually is accomplished by matching accounts payable invoices to receiving reports, and matching sales invoices to shipping documents. The procedure described above guarantees that both sides of the accounting entry are recorded in the same period. The inventory amount is recorded through the physical count and valuation, whereas the accounts payable/cost of sales amount is recorded through the matching procedure. This method implies all purchases are fob destination and all sales are fob shipping point. Although this is unlikely to be the case, the approach works in practice because goods in transit are typically not significant, and the procedure is applied consistently. Companies that have a significant volume of goods in transit and varying terms regarding transfer of ownership should scrutinize the inventory cutoff calculations. For example, a fob destination sale that was in transit at period end would be recorded prematurely using the method described above. As a result, pretax income would be overstated by the gross margin on the sale, accounts receivable would be overstated, and inventory would be understated. Such a situation normally is considered more of a revenue recognition issue (discussed in Chapter 17) than an inventory issue. The effect of a similar situation for a purchase would merely affect the balance sheet, because there is no margin involved for the buyer. In situations where a strict legal determination of ownership is impractical or other cutoff questions arise, the terms of the sales agreement, the intent of the parties involved, industry practices, and other factors should be considered.

Achieving an accurate cutoff is enhanced by controlling the shipping, receiving, and transfer activity during the physical count. Also, source documents (e.g., receiving reports, shipping reports, bills of lading) pertaining to goods shipped and received around the inventory date must be reviewed closely to verify that transactions have been recorded in the proper period.

In a perpetual inventory system, detailed records are maintained on an ongoing basis for each inventory item. The inventory balance is increased as items are purchased or inventoriable costs are incurred, and the balance is reduced as items are sold or transferred. Cost of sales reflects actual costs relieved from inventory. The level of sophistication of the records can vary dramatically, from manual entries posted directly to the general ledger to refined automated systems that use standard costs and detailed subsidiary records.

Cycle counting may be used with a perpetual inventory system to supplement other control procedures and to spread the physical counting effort throughout a period. A cycle count involves physically counting a portion of the inventory and comparing the quantity to that indicated by the perpetual records. Cycle counts test the reliability of the perpetual records. In connection with the ABC method of inventory control, in which higher cost items receive a greater degree of continuous control than other items, cycle counts are performed more frequently for high-cost items. Successful results from interim cycle counts can justify reliance on the perpetual records, and thereby eliminate the need to perform a companywide physical inventory at the fiscal year-end date. This approach generally is recommended in situations where unusual book to physical adjustments have not been identified during the interim cycle counts.

The points made above about periodic inventory system cutoff are equally applicable to a perpetual system. In fact, the detailed record-keeping procedures regularly performed in a perpetual system generally make the period-end cutoff process less burdensome.

Products produced in individual units or batches, and requiring varying amounts of materials and labor (often to customer specifications) compared to other products, normally are costed using the job-order method. This technique is common in the furniture, printing, and robotics industries.

Costs of direct material and direct labor are assigned to specific jobs, based on actual usage. Usage information frequently is obtained from material requisition forms and labor time cards. Overhead typically is applied using a predetermined annual rate adjusted periodically to approximate actual costs.

Products produced in large quantities are normally costed using an averaging method called process costing. Companies in the textile, chemical, mining, and glass industries typically use process costing. Production runs are costed based on standard costs, which are the costs expected under efficient operating conditions. The total of all standard costs reported during each period is compared to actual costs incurred, based on general ledger account totals used to capture each cost category. Variances between standard costs and actual costs are analyzed and may be included in inventories or charged to expense, depending on the cause of the variance. No attempt is made to match costs of specific materials and labor to inventory units, because doing so would be highly impractical. A standard cost system can be effective in a process costing environment because of the relative predictability of unit costs. Standard costs can be developed based on each product's bill of materials and engineering specifications.

Materials contained in and traceable to a finished product are designated as direct materials. Because direct materials are a physical component of inventory items, and their cost is based on invoices from vendors, accounting for direct material costs is not difficult as long as quantities are tracked accurately. Freight and other costs of receiving materials also are inventoriable. Generally, freight-in is included as a portion of direct material, whereas receiving costs are included in the overhead pool. Paton & Paton indicate the cost of materials should be recorded net of related purchase discounts under the theory that income is not generated as a result of acquiring goods or services.^[315]

For operational purposes, material price variances and usage variances are identified to highlight deviations from standard amounts. Use of the lower of cost or market criteria (described in Section 20.5(b) of this chapter) determines whether unfavorable variances or other factors such as spoilage require a write-down of the carrying amount for financial accounting purposes.

Payroll and employee benefits costs of employees incurred in the technical operations of converting raw materials to finished product are considered direct labor. It is more difficult to associate labor costs directly with inventory than to associate material costs in that way. Labor reporting systems are often the most cumbersome part of collecting inventory costs. Labor price variances and labor efficiency variances are identified to highlight the reasons for deviations from standard costs.

Overhead, often referred to as factory overhead or indirect manufacturing costs, consists of all costs—other than direct material and direct labor—directly related to and adding value to the manufacturing process.

ARB No. 43 states that general and administrative costs can be included in inventories only if they are clearly related to production and that selling expenses should never be included in the inventory. In addition, amounts of wasted materials (spoilage) regardless of whether it is normal or abnormal should be treated as a current period charge. For many companies, determining which costs are appropriate inventoriable costs under these criteria may be difficult. Costs typically included in the overhead pool are:

Other less obvious costs appropriate to charge to the overhead pool include (ARB No. 43 as amended by Statement of Financial Accounting Standards (SFAS) No. 151):

SFAS No. 151 specifies that fixed overhead should be allocated to inventories based on the normal capacity of the productive facility.

Evaluating and documenting costs that may be capitalized as part of overhead cost requires judgment based on consideration of a number of factors, including a company's organizational structure and the nature of its accounting records. For example, a company that is highly decentralized may have all of its direct production costs segregated at its manufacturing facilities. The personnel, purchasing, and accounting functions related to manufacturing may all be located at the facility and their costs clearly identified. On the other hand, a highly centralized company may have all its personnel, purchasing, and accounting functions in a central location supporting sales and corporate functions as well as manufacturing. In this case, it is more difficult to establish and document a direct relationship to the production process. However, documenting a direct relationship is necessary to support including those costs in inventory under generally accepted accounting principles.

As described above, certain costs, such as selling expenses, abnormal costs, and a defined portion of general and administrative costs, are to be excluded from inventory and charged to operations as incurred. ARS No. 13 suggests relevant costs to be allocated to the overhead pool should be determined by considering a "cause-effect" relationship. "Causes are actions taken to manufacture products or to maintain the facilities and organization to manufacture products. The effects are the costs." The Research Study indicates that in conventional practice all costs associated with the selling function generally are treated as expenses of the period in which incurred, as are costs of general administration (excluding factory administration), finance, and general research. "Accounting for Research and Development Costs," FASB Statement No. 2, requires that all research and development costs encompassed by the Statement be charged to expense when incurred. FASB Statement No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed," requires that all costs incurred to establish the technological feasibility of a computer software product be charged to expense as research and development. Once technological feasibility is established, software production costs are capitalized and amortized on a product-by-product basis. Capitalization of computer software costs ends when the product is available for general release to customers. Costs related to maintenance and customer support are expensed as incurred or when the related revenue is recognized, whichever occurs first. Costs incurred to duplicate the software, documentation, and training materials and to physically package the product for distribution are capitalized as inventory.

Selling costs are appropriately charged to expense as incurred, because such costs typically cannot be identified with individual sales and relate to goods previously sold rather than to inventory on hand. The question of deferring certain selling and marketing costs that relate to transactions not yet recognized for accounting purposes (i.e., in order to record the expense in the same period as the related revenue) is controversial and beyond the scope of this chapter. Nevertheless, if such costs are deferred, they should not be included with or classified as inventory. Numerous other types of costs raise questions about whether they should be included in the overhead pool or treated as a period cost. These costs include purchasing and other costs of ordering, quality control, warehousing, cost accounting, and carrying costs such as interest and insurance (on the inventory items and on the warehouse). The decision to include a cost in the overhead pool requires considerable judgment. In addition to using the "cause-effect" approach described earlier, challenging whether the cost adds value to the product is often useful. Observation of current practice indicates all of the above items except interest are included in the overhead pool by some companies and excluded by others. The FASB Statement No. 34, "Capitalization of Interest Cost," states, "Interest cost shall not be capitalized for inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis because in the Board's judgment, the informational benefit does not justify the cost of so doing."

Including judgmental-type costs in inventory increases current assets and shareholders' equity. The effect on income of a particular period can be in either direction, depending on the relative inventory balances at the beginning and end of the period. However, for a growing company, a broadly defined overhead pool generally serves to increase income reported each period.

Because indirect production costs cannot be directly associated with a particular inventory unit, the costs are generally assigned to various units by using allocation methods. There are several means of allocating overhead costs to inventory and cost of sales. The traditional method has been to develop an overhead rate based on overhead cost per direct labor hour or direct labor dollar. This method allocates overhead to inventory and cost of sales in proportion to the amount of labor used. Other allocation bases may be more logical in certain circumstances. For instance, use of machine-hours may be a preferable method of overhead allocation for highly automated processes. Recording overhead costs by function and department can significantly improve the cost allocation process. Logical statistical methods can be established to allocate indirect costs. Such refinements can produce more meaningful results than use of a single plant-wide overhead rate. Increased accuracy and control results from using more specific and relevant overhead allocation methods.

Possible methods of allocating indirect costs include:

The level of sophistication in allocating indirect costs and determining overhead absorption rates can profoundly affect the inventory valuation and such other important matters as product margins and pricing.

"Accounting Changes Related to the Cost of Inventory," FASB Interpretation No. 1, indicates a change in composition of the elements of cost included in inventory is an accounting change. Reporting of such changes should conform with Accounting Principles Board (APB) Opinion No. 20, "Accounting Changes." Preference should be based on an improvement in financial reporting, not on the basis of the income tax effect alone.

In 1984, the Accounting Standards Executive Committee (AcSEC) of the American Institute of Certified Public Accountants (AICPA), in Section 6 of an issues paper, "Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories" (the AICPA Issues Paper), indicated that companies may apply the lower-of-cost-or-market provisions of ARB No. 43 to LIFO inventories on the basis of "reasonable groupings of inventory items." Further, it stated that in general a pool constitutes a reasonable grouping. Section 6 of the AICPA Issues Paper also indicates companies with more than one pool may aggregate pools for purposes of lower-of-cost-or-market determinations if the compositions of the pools are similar. The AICPA Issues Paper emphasizes the importance of "the character and composition" of the inventory in making lower-of-cost-or-market determinations. The Task Force also added the following caution: If the compositions of the pool are significantly dissimilar, they should not be aggregated.

The AICPA Issues Paper includes a discussion of the treatment of obsolete or discontinued products within the lower-of-cost-or-market review. The Task Force and AcSEC did not agree on this issue. AcSEC believes the item-by-item approach should be used for identified product obsolescence and product discontinuance, while the Task Force believes either the item-by-item approach or the aggregate-by-pool approach is appropriate. Because there was disagreement between the Task Force and AcSEC, companies can use either the item-by-item approach or the aggregate-by-pool approach for identified product obsolescence and product discontinuance. However, whatever approach used should be applied consistently.

The specific goods (or specific identification) method is normally the simplest LIFO approach to apply and understand. Inventory quantities and costs are measured in terms of individual units. Each item or group of similar items is treated as a separate inventory pool (e.g., a specific grade of tobacco).

The advantage of the specific goods method is that it is easy to conceptualize because LIFO costs are associated with specific items in inventory. This method has been used most frequently by companies that have basic inventory items, such as steel or commodities, and deal with a relatively low volume of transactions.

There are disadvantages, however, in using the specific goods method, especially if the inventory has a wide variety of items or if items change frequently (e.g., for technological reasons). In such circumstances, the specific goods method might become complicated, may prove costly to administer, and may produce unwanted LIFO liquidations.

The dollar-value method overcomes most of the disadvantages of the specific identification method. The distinguishing feature of the dollar-value LIFO method is that it measures inventory quantities in terms of fixed dollar equivalents (base-year costs), rather than quantities and prices of individual goods. Similar items of inventory are aggregated to form inventory pools. Changes in quantities and changes in product mix within a pool are ignored. Increases or decreases in each pool are identified and measured in terms of the total base-year cost of the inventory in the pool, rather than of the physical quantities of items.

One of the most important aspects of dollar-value LIFO is selecting the pools to be used in the computations. A careful assignment of inventory items to pools will avoid most of the limitations of the specific identification method noted above. Generally, the fewer the pools, the lower the likelihood of a liquidation and the lower the resulting taxable income. Fewer pools also minimize the administrative burden associated with accounting for LIFO inventories. The AICPA Issues Paper concludes that it is not feasible to formulate detailed guidance for selecting pools that could apply to all enterprises. It advises that the objective of LIFO inventory pooling is to group inventory items to match most recently incurred costs to current revenues, after considering the manner in which the company operates its business; establishing separate pools with the principal objective of facilitating inventory liquidations would not be considered acceptable. Items that comprise a similar or identical product sold by the enterprise should be included in the same pool. The existence of separate legal entities (e.g., subsidiaries), by itself, does not justify establishing separate LIFO pools for consolidated financial reporting purposes.

For tax purposes, LIFO is applied by individual corporations rather than consolidated groups. Each subsidiary must establish its own separate pools. If an affiliated group filing a consolidated income tax return has three subsidiaries in the same line of business, a single LIFO pool encompassing the operations of all three subsidiaries cannot be adopted for tax purposes even though one of the subsidiaries does central purchasing for all three. The IRS frequently challenges the nature and number of pools selected; both must be specified when a company applies to the IRS for an accounting change to the LIFO inventory method. Once a company has established the number of pools it will use in the year LIFO is adopted, changes can be made only with permission from the IRS. A method of pooling is considered an accounting method for tax purposes. Therefore, any change in the method of poolings requires IRS approval.

The broadest definition of a pool is the natural business unit pool. This includes, in a single pool, all inventories, including raw materials, work in process, and finished goods. This method is only available to companies—generally manufacturers and processors—whose operations consist of a single product line, or more than one if they are related. The natural business unit pool is attractive to many companies because the use of a single pool simplifies the LIFO calculations and reduces the number of layer liquidations.

Companies that do not qualify for natural business unit pooling or that wish to elect LIFO for only a portion of their inventory may elect the multiple pool method. Each of the multiple pools should consist of "substantially similar" inventory items.

Various computational techniques are used to apply the dollar-value method—the double-extension link-chain, internal indexes, the retail LIFO method (a variation of the link-chain technique) and other simplified external index techniques. These techniques have the objective of determining the base-year cost of the current-year inventory. The double-extension technique converts current-year amounts directly to base-year costs. The link-chain technique achieves the objective indirectly by developing an index based on the current-year cost increases and multiplying that index by the prior-year cumulative index. The internal index technique uses a representative sample of the entire population (e.g., 70 percent of all items in the pool or a statistical sample) that are double-extended to convert current-year amounts to base-year costs. The retail LIFO method is a dollar-value method that uses base-year retail value instead of base-year cost to compute inventory changes. The simplified external index technique applies 100 percent of the external index (e.g., price indexes published by the Bureau of Labor Statistics [BLS] to the current-year cost).

The double-extension technique extends ending inventory quantities twice—once at current-year costs (unit costs for the current period, determined using another method, typically FIFO) and once at base-year costs. This double extension procedure provides the current-year index (total current-year cost divided by total base-year cost).

To determine the net inventory change for the year, the ending inventory expressed in terms of base-year costs is compared to the beginning-of-the-year inventory expressed in terms of base-year costs. If the ending inventory at base-year costs exceeds the beginning inventory at base-year costs, a new LIFO layer has been created. The new layer is valued by applying the ratio of the ending inventory at current costs (using one of the approaches described later in this chapter) to the ending inventory at base-year costs. This ratio is generally referred to as LIFO index. If the ending inventory at base-year costs is less than beginning inventory at base-year costs, a LIFO liquidation has occurred. When a liquidation has occurred, decrements in base-year costs are deducted from the layers of earlier years beginning with the most recent prior year.

When an item enters the inventory for the first time, a company must either use its current cost or determine its base-year cost. Under IRS regulations, current cost must be used unless the company is able to reconstruct a base-year cost. The use of manufacturing specifications or other methods may allow a company to determine what the cost of a new item would have been in the base year. This effort may be worthwhile, because it may calculate a base-year cost that is lower than the current-year cost, most likely due to inflation in the cost of materials and labor. Use of a lower base-year cost in the LIFO calculations increases the current-year index and, thereby, lowers the inventory balance and pretax income. In other words, by reconstructing a base-year cost for new items, the impact of LIFO is normally maximized.

Companies that use the double-extension technique must retain indefinitely a record of base-year unit costs of all items in inventory at the beginning of the year in which LIFO was adopted, as well as any base-year unit costs developed for new items added in subsequent years. Exhibit 20.2 is an example of the LIFO double-extension technique.

The double-extension technique can prove cumbersome, particularly when the base year extends back a number of years. Changes in product specifications and manufacturing methods are common in many industrial companies. The link-chain method eliminates the burden of reconstructing base-year costs and so is a more efficient means of computing LIFO cost. In determining a LIFO index, an IRS rule of thumb holds that at least 70 percent of the total value of the pool should be matched to the prior-year costs to achieve a representative sample. If a statistical, random sampling technique is used, fewer items may be matched to obtain acceptable results.

Figure 20.2. Example of LIFO double-extension technique.

Under the link-chain technique, the ending inventory is double- extended at both current-year unit costs and prior-year unit costs. The respective extensions are then totaled, and the totals are used to compute a current-year index. This current-year index is multiplied by the prior-year cumulative LIFO index to obtain a current-year cumulative index. Total current-year costs are divided by the current-year cumulative index to determine base-year costs. If ending inventory stated at base-year cost exceeds beginning inventory stated at base-year cost, a new LIFO layer has been created. The new layer is valued by applying the applicable cumulative index (using one of the approaches described later in this chapter) to the increments stated at base-year cost. If ending inventory stated at base-year cost is less than beginning inventory stated at base-year cost, a LIFO liquidation has occurred. The double extension and link-chain techniques produce identical results in the year LIFO is adopted. In subsequent years, however, changes in inventory mix and differences in the way new inventory items are handled usually create at least minor differences.

When a liquidation has occurred, decrements in base-year costs are deducted from the layers of earlier years, beginning with the most recent prior year.

If new items are included in the calculation of an index under the link-chain method, a unit cost would be reconstructed using prior-year, rather than base-year, costs. The reason is that the link-chain current-year index attempts to measure inflation for the most recent year. Exhibit 20.3 is an example of the LIFO link-chain technique and compares the results obtained to those calculated using the double-extension technique in Exhibit 20.2.

Like the retail inventory method described earlier, the retail LIFO method is used most frequently by department stores and other retailers that sell many and varied goods. In determining the ratio of cost to retail value for the year, the retail LIFO method differs from the conventional retail inventory method (which approximates the lower of average cost or market) in two basic respects: (1) the ratio is based on transactions during the year (beginning inventories are excluded, except in the year of adoption) and (2) net markdowns during the year (exclusive of promotional markdowns—1979 IRS ruling) are reflected in determining the sales value of inventory for purposes of calculating the ratio of cost to retail. Use of retail LIFO permits these companies to match most recent costs against current revenues and, as a result, values inventory at older costs. The retail method of LIFO is an adaption of the dollar-value LIFO method. However, the retail method differs from other applications of dollar-value LIFO because in recording inventory input and output, retail sales values are used rather than cost. Items in the closing inventory are initially priced at retail value (i.e., intended sales value), and the retail value of the closing inventory in each department is converted to cost by applying a factor reflecting the relationship of those values to cost.

Most retailers that adopt LIFO continue to maintain their books for internal merchandise management and accounting purposes at the lower of non-LIFO cost or market, following the retail method described earlier in this chapter. The internal records are converted to LIFO only for external financial reporting and tax purposes.

The retail LIFO method requires that retail selling prices be adjusted for markdowns to state inventories at approximate cost rather that at the lower-of-cost-or-market, as frequently followed under the non-LIFO retail method. To state the inventory at cost, the cost complement under the retail LIFO method includes the effects of markdowns. However, temporary or promotional markdowns are not included in the cost complement calculation, because the physical inventory would never reflect such markdowns (i.e., they are applied separately at the time of sale).

Department stores using the retail LIFO method are allowed to use price indexes published by the IRS based on information furnished by the Bureau of Labor Statistics (BLS) BLS to convert the current-year retail value of the closing inventory to base-year retail value. In addition, other retailers that maintain a reasonably full line of inventory that comprises a representative cross-section of the inventory included in the BLS departmental groupings may use the BLS retail price indexes. Retailers that do not meet these criteria must develop their own indexes from internally generated figures, unless they make an election to use "simplified" LIFO (under which indexes are based on government-published indexes). Because price indexes are a significant element of the LIFO retail computations, internally generated indexes must be constructed on a sound basis and appropriate records must be maintained for examination by the IRS.

Figure 20.3. Example of LIFO link-chain technique.

In a retail LIFO calculation, the current year's inventory at base-year retail value is compared with the prior year's inventory at base-year retail value to determine if there is a current-year increment or decrement. A current-year increment at base-year retail value is converted to current-year retail value by use of the BLS or other computed price index and then reduced to LIFO cost by using a factor reflecting the ratio of current-year cost to retail value for the year. The LIFO cost of the increment is added to the beginning-of-year LIFO inventory cost to arrive at the end-of-year LIFO inventory.

A current-year decrement is applied against the most recent LIFO layer(s) at base-year retail value. The decrement is converted to retail value applicable to those layers by use of the index associated with such layers. The retail value so determined is reduced to LIFO cost by the factor(s) reflecting the ratio of cost to retail associated with the particular layers being liquidated. The LIFO cost of the decrement is then subtracted from the beginning-of-year LIFO inventory to arrive at the end-of-year LIFO inventory. Exhibit 20.4 is an example of the retail LIFO computation.

Regardless of the technique used to compute LIFO values, an approach to price any newly created current-year LIFO layer must be selected and used consistently.

In addition, any other method that in the opinion of the IRS clearly reflects income may be used to price current-year LIFO layers.

The treatment of new items is one of the more controversial aspects involved in using LIFO. Important considerations in this area include what constitutes a new item and how the LIFO cost of new items should be determined.

Improper designation of items as new can significantly affect reported income if base-year costs are not reconstructed. The SEC expresses its concern in this area in Financial Reporting Release (FRR) 1 (Section 205) and again in Staff Accounting Bulletin No. 58, "Last-In, First-Out (LIFO) Inventory Accounting Practices for Financial Reporting Purposes" (SAB Topic 5.L), by stating "insignificant and sometimes arbitrary" differences are not sufficient justification for new product designation, particularly when it result in a significant increase in reported income.

Section 4-21 of the AICPA Issues Paper provides the following guidance for determining if an item should be classified as a new item for financial reporting purposes:

The AICPA Issues Paper concludes (Section 4-27) that for financial reporting purposes, if the double extension or an index technique is used, the base-year cost of the new item should be reconstructed and the base-year cost should be estimated if it is not otherwise objectively determinable. However, if the link-chain technique is used, the AICPA Issues Paper concludes that "reconstruction of prior years' costs is unnecessary because that technique produces approximately the same results as reconstruction." To avoid the problems generally encountered in reconstructing base-year costs, companies may consider using the link-chain method if they meet IRS requirements. Some companies that frequently add new items are not able to satisfy the IRS's stringent qualifications for the use of the link-chain method. And, reconstructing base-year costs using vendor quotes or price lists is not always practical. Consequently, these companies would have added new items at current-year costs for tax purposes. Although allowable for tax purposes, adding new items to inventory using current-year costs for financial reporting would conflict with the recommendation in the AICPA Issues Paper.

In the year LIFO is adopted, any market write-downs or other valuation allowances must be restored so that the opening inventory is stated at cost. Also, because the prior year's ending inventory (presumably at FIFO or average cost) becomes the opening LIFO inventory, there is no adjustment for any cumulative effect of a change in accounting principle or disclosure of pro forma amounts for prior years. APB Opinion No. 20 cites the change in inventory pricing from FIFO to LIFO as an example of a change in accounting principle for which the cumulative effect adjustment and pro forma disclosures may be omitted.

In SAB Topic 5.L, the SEC staff endorsed the AICPA Issues Paper, saying it represents an accumulation of existing acceptable LIFO accounting practices, and companies and their auditors should refer to it for guidance. The AICPA Issues Paper recommends that all companies using LIFO follow these three LIFO-related disclosures required for SEC registrants:

The AICPA Issues Paper also provides practical implementation guidance on expanded supplemental non-LIFO disclosures (such as notes to the financial statements and other supplemental information that disclose the pro forma effects of using FIFO or some other acceptable inventory method) and the use of LIFO applications for financial reporting purposes that differ from the applications used for income tax purposes.

Practice Bulletin No. 2, "Elimination of Profits Resulting from Intercompany Transfers of LIFO Inventories," issued by the AcSEC of the AICPA, which also deals with LIFO, indicates intercompany profits arising from LIFO liquidations caused by transfers between or from LIFO pools within a reporting entity should be deferred until such profits are realized by the reporting entity through dispositions outside the consolidated group.

In Accounting Series Release (ASR) No. 293, the SEC indicated LIFO accounting has been unduly influenced by IRS rules, and the amended IRS regulations that allow companies to compute LIFO differently for financial reporting and tax purposes are viewed very positively by the Commission. In this manner, companies can select for financial reporting purposes LIFO techniques (from those described above) that best reflect the company's circumstances, rather than being forced to use IRS-mandated methods that dictate the income tax return calculations. The SEC also indicated its concern that supplemental income disclosures based on non-LIFO methods may be misleading. This concern is mitigated when these three additional disclosures are made:

As a result of the SEC release, publicly held companies that disclose supplemental income information based on non-LIFO methods also regularly make the three additional disclosures recommended by the SEC.

Written policies and procedures for performing LIFO computations and determining LIFO pools can improve the quality and consistency of the results. Because of the complexity of the calculations, a thorough detailed review by someone other than the preparer is worthwhile.

The FASB staff announced, in EITF Topic No. D-31, "Temporary Differences Related to LIFO Inventory and Tax-to-Tax Differences," its positions that FASB Statement No. 109, "Accounting for Income Taxes" (Statement 109), "requires comprehensive recognition of deferred tax liabilities and assets for temporary differences and operating loss and tax credit carryforwards." Accordingly, deferred taxes should be recognized under Statement No. 109 for LIFO inventory temporary differences (i.e., an excess of LIFO inventory for financial reporting over its tax basis requires recognition of a deferred tax liability).

The use of locks, guards, restricted access, and other physical means to secure valuable inventory items improves control and discourages theft. In addition, proper shelter and storage facilities reduce deterioration and spoilage. As with most control measures, a cost/benefit evaluation should be performed to determine the extent to implement physical safeguards.

Documentation of the procedures and policies authorized by management for inventory control should exist and be updated regularly for changes. The documentation should be readily available to and understood by employees who perform these procedures. Systems documentation is particularly useful for training new employees and minimizing disruption from other changes in personnel.

Regular comparisons of physical goods to the accounting records and reconciliations of various source documents can improve control by identifying losses, problems, or other matters warranting management's timely attention. A perpetual inventory system is required to make effective use of reconciliations as a control. Reconciliations should be reviewed by the individual who supervises the person who prepares them. Many specific inventory reconciliation procedures are included in the lists of specific control procedures presented in Subsections 20.4(c) and 20.4(d).

In the inventory area, the use of budgets is most effective for fixed and semifixed costs. Comparison of actual costs to the budgeted amounts can identify matters for further investigation. Explanations of budget variances can assist management in determining whether to record actual costs or standard costs as the inventory amount.

For variable costs, the use of regularly updated standard costs and the related variance analysis can identify differences between actual costs and standard costs, regardless of the level of volume. These differences should be examined to ascertain what caused them and what corrective action may be required.