Goods in Transit

At year-end, any goods in transit from seller to buyer must be included in one of those parties' inventories based on the conditions of the sale. Such goods are included in the inventory of the firm financially responsible for transportation costs. This responsibility may be indicated by a variety of peculiar shipping acronyms such as FOB, which is used in overland shipping contracts, or FAS, CIF, C&F, and ex-ship, which are used in maritime contracts.

The term FOB is an abbreviation of “free on board.” If goods are shipped FOB destination, transportation costs are paid by the seller and title does not pass until the carrier delivers the goods to the buyer. These goods are part of the seller's inventory while in transit. If goods are shipped FOB shipping point, transportation costs are paid by the buyer and title passes when the carrier takes possession of the goods. These goods are part of the buyer's inventory while in transit. The terms FOB destination and FOB shipping point often indicate a specific location at which title to the goods is transferred, such as FOB Cleveland. This means that the seller retains title and risk of loss until the goods are delivered to a common carrier in Cleveland who will act as an agent for the buyer. The rationale for these determinations originates in agency law, since transfer of title is conditioned upon whether the carrier with physical possession of the goods is acting as an agent of the seller or the buyer.

A seller who ships FAS (free alongside) must bear all expense and risk involved in delivering the goods to the dock next to (alongside) the vessel on which they are to be shipped. The buyer bears the costs of loading and shipment. Title passes when the carrier, as agent for the buyer, takes possession of the goods.

In a CIF (cost, insurance, and freight) contract, the buyer agrees to pay in a lump sum the cost of the goods, insurance costs, and freight charges. In a C&F (cost and freight) contract, the buyer promises to pay a lump sum that includes the cost of the goods and all freight charges. In either case, the seller must deliver the goods to the buyer's agent/carrier and pay the costs of loading. Both title and risk of loss pass to the buyer upon delivery of the goods to the carrier.

A seller who delivers goods ex-ship bears all expense and risk until the goods are unloaded, at which time both title and risk of loss pass to the buyer.

Consignment Arrangements

In consignment arrangements, the consignor ships goods to the consignee, who acts as the agent of the consignor in trying to sell the goods. In some consignments, the consignee receives a commission upon sale of the goods to its customer. In other arrangements, the consignee “purchases” the goods simultaneously with the sale of the goods to the customer. Goods on consignment are included in the inventory of the consignor and excluded from the inventory of the consignee.

Product Financing Arrangements

ASC 470-40 addresses the issues involved with product financing arrangements. A product financing arrangement is a transaction in which an entity (referred to as the “sponsor”) simultaneously sells and agrees to repurchase inventory to and from a financing entity. The repurchase price is contractually fixed at an amount equal to the original sales price plus the financing entity's carrying and financing costs. The purpose of the transaction is to enable the sponsor enterprise to arrange financing of its original purchase of the inventory.

FASB ruled that the substance of this transaction is that of a borrowing transaction, not a sale. That is, the transaction is, in substance, no different from the sponsor directly obtaining third-party financing to purchase inventory. ASC 470-40 specifies that the proper accounting by the sponsor is to record a liability in the amount of the selling price when the funds are received from the financing entity in exchange for the initial transfer of the inventory. The sponsor proceeds to accrue carrying and financing costs in accordance with its normal accounting policies. These accruals are eliminated and the liability satisfied when the sponsor repurchases the inventory. The inventory is not removed from the statement of financial position of the sponsor and a sale is not recorded. Thus, although legal title has passed to the financing entity, for purposes of measuring and valuing inventory, the inventory is considered to be owned by the sponsor.

For more information, see the chapter on ASC 470.

Sales Made with the Buyer Having the Right of Return

Another issue requiring special consideration exists when a buyer is granted a right of return, as defined by ASC 605-15.¹ The seller must consider the propriety of recognizing revenue at the point of sale under such a situation. The sale is recorded only when six specified conditions are met including the condition that the future amount of returns can be reasonably estimated by the seller. If a reasonable estimate cannot be made, then the sale is not recorded until the earlier of the expiration date of the return privilege or the date when all six conditions are met. Similar to product financing costs, this situation results in the seller continuing to include the goods in its measurement and valuation of inventory even though legal title has passed to the buyer. For more information see chapter on ASC 605.

Raw Materials and Merchandise Inventory

For raw materials and merchandise inventory which are purchased outright, the identification of cost is relatively straightforward. The cost of these purchased inventories will include all expenditures incurred in bringing the goods to the point of sale and converting them to a salable condition. These costs include the purchase price, transportation costs (freight-in), insurance while in transit, and handling costs charged by the supplier.

Purchases can be recorded at their gross amount or net of any allowable discount. If recorded gross, the discounts taken represent a reduction in the purchase cost for purposes of determining cost of goods sold. On the other hand, if they are recorded net, any lost discounts are treated as a financial expense, not as cost of goods sold. The net method is considered to be theoretically preferable, but the gross method is simpler and, thus, more commonly used. Either method is acceptable under GAAP, provided that it is consistently applied.

Inventory purchases and sales with the same counterparty. Some enterprises sell inventory to another party from whom they also acquire inventory in the same line of business. These transactions may be part of a single or separate arrangements and the inventory purchased or sold may be raw materials, work-in-process, or finished goods. These arrangements require careful analysis to determine if they are to be accounted for as a single exchange transaction under ASC 845, Nonmonetary Transactions, and whether they are to be recognized at fair value or at the carrying value of the inventory transferred.² More detailed information can be found in the chapter on ASC 845.

Inventory Hedges

One notable exception to recording inventories at cost is provided by the hedge accounting requirements of ASC 815. If inventory has been designated as the hedged item in a fair value hedge, changes in the fair value of the hedged inventory are recognized on the statement of financial position as they occur, with the offsetting charge or credit recognized currently in net income. Hedging is discussed in detail in Chapter 10.

Manufacturing Inventories

Inventory cost in a manufacturing enterprise includes both acquisition and production costs. This concept is commonly referred to as full absorption or full costing. As a result, the WIP and finished goods inventories include direct materials, direct labor, and an appropriately allocated portion of indirect production costs referred to as indirect overhead.

Under full absorption costing, indirect overhead costs—costs that are incidental to and necessary for production—are allocated to goods produced and, to the extent those goods are uncompleted or unsold at the end of a period, are included in ending WIP or finished goods inventory, respectively. Indirect overhead costs include such costs as

Indirect overhead is comprised of two elements, variable and fixed overhead. ASC 330-10-30-3 clarifies that variable overhead is to be allocated to work-in-process and finished goods based on the actual usage of the production facilities. Fixed overhead, however, is to be allocated to work-in-process and finished goods based on the normal expected capacity of the enterprise's production facilities, with the overhead rate recomputed in instances when actual production exceeds the normal capacity. (ASC 330-10-30-3) Initially, this may appear to be an inconsistent accounting method; however, the use of this convention ensures that the inventory is not recorded at an amount in excess of its actual cost, as illustrated in the following example:

For the purpose of determining normal productive capacity, it is expected that capacity will vary from period to period based on enterprise-specific or industry-specific experience. Management is to formulate a judgment regarding a reasonable range of normal production levels expected to be achieved under normal operating conditions.

The enterprise may incur unusually large expenses resulting from idle facilities, excessive waste, spoilage, freight, or handling costs. ASC 330-10-30-7 clarifies that when this situation occurs, the abnormal portion of these expenses is to be treated as a cost of the period incurred and not to be allocated to inventory. Most general and administrative expenses are also expensed as incurred. Selling expenses are also expensed as incurred.

Generally, interest costs incurred during the production of inventory are not capitalized under ASC 835-20. A complete discussion regarding the capitalization of interest costs is provided in the chapter on ASC 835.

Determining Inventory Cost

The theoretical basis for valuing inventories and cost of goods sold requires assigning production and/or acquisition costs to the specific goods to which they relate. This method of inventory valuation is usually referred to as specific identification. Specific identification is generally not practical inasmuch 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, such as automobiles or heavy machinery. Because of the limited applicability of specific identification, it is necessary to make certain assumptions regarding the cost flows associated with inventory. Although these cost flow assumptions are used for accounting purposes, they may or may not reflect the actual physical flow of the inventory.

Cost Flow Assumptions

The most common cost flow assumptions used are specified in ASC 330-10-30-9:

1. first-in, first-out (FIFO),
2. last-in, first-out (LIFO), and
3. weighted-average.

Additionally, there are variations in the application of each of these assumptions which are commonly used in practice. ASC 330-10-30-9 points out that:

“The major objective in selecting a method should be to choose the one which, under the circumstances, most clearly reflects periodic income.”

In selecting which cost flow assumption to adopt as its accounting policy for a particular type of industry, management should consider a variety of factors. First, the industry norm should be examined, as this will facilitate intercompany comparison by financial statement users. The appropriateness of using a particular cost flow assumption will vary depending on the nature of the industry and the expected economic climate. The appropriate method in a period of rising prices differs from the method that is appropriate for a period of declining prices. Each of the foregoing assumptions and their relative advantages or disadvantages are discussed below. Examples are provided to enhance understanding of the application.

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 most closely parallel the physical flow of the units in most industries. The strength of this cost flow assumption lies in the inventory amount reported on the statement of financial position. Because the earliest goods purchased are the first ones removed from the inventory account, the remaining balance is composed of items priced at more recent cost. This yields results similar to those obtained under current cost accounting on the statement of financial position. However, the FIFO method does not necessarily reflect the most accurate income figure as older, historical costs are being charged to cost of goods sold and matched against current revenues.

Last-In, First-Out (LIFO)

The LIFO method of inventory valuation assumes that the last goods purchased are the first goods used or sold. This allows the matching of current costs with current revenues and provides the best measure of gross profit. However, unless costs remain relatively unchanged over time, the LIFO method will usually misstate the ending inventory statement of financial position amount, because LIFO inventory usually includes costs of acquiring or manufacturing inventory that were incurred in earlier periods. LIFO does not usually follow the physical flow of merchandise or materials. However, the matching of physical flow with cost flow is not an objective of accounting for inventories.

LIFO accounting is actually an income tax concept. Consequently, the rules regarding the application of the LIFO method are not set forth in U.S. GAAP, but rather, are found in the U.S. Internal Revenue Code (IRC) §472. U.S. Treasury regulations provide that any taxpayer that maintains inventories may select LIFO application for any or all inventoriable items. This election is made with the taxpayer's income tax return on Form 970 after the close of the first tax year that the taxpayer intends to use (or expand the use of) the LIFO method.

The quantity of ending inventory on hand at the beginning of the year of election is termed the “base layer.” This inventory is valued at actual (full absorption) cost, and unit cost for each inventory item is determined by dividing total cost by the quantity on hand. At the end of the initial and subsequent years, 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 the following costing methods 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 more clearly reflects income (for income tax purposes, this method must meet with the approval of the IRS Commissioner).

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.

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 reduce or eliminate previously established LIFO layers. Once any part of a LIFO layer has been eliminated, it cannot be reinstated after year-end. For example, if in its first year after the election of LIFO an enterprise establishes a LIFO layer (increment) of ten units, then in the next year inventory decreases by four units, leaving the first layer at six units, the enterprise is not permitted in any succeeding year to increase the number of units in the first year layer back up to the original ten units. The quantity in the first layer remains at a maximum of six units subject to further reduction if decrements occur in future years. Any unit increases in future years will create one or more new layers. The effect of LIFO liquidations in periods of rising prices is to transfer, from ending inventory into cost of goods sold, costs that are below the current cost being paid. Thus, the resultant effect of a LIFO liquidation is to increase income for both accounting and income tax purposes. Because of this, LIFO is most commonly used by companies in industries in which levels of inventories are consistently maintained or increased over time.

LIFO liquidations can be either voluntary or involuntary. A voluntary liquidation occurs when an enterprise deliberately lets its inventory levels drop. Voluntary liquidations may be desirable for a number of reasons. Management might consider the current price of purchasing the goods to be too high, a smaller quantity of inventory might be needed for efficient production due to conversion to a “just-in-time” production model, or inventory items may have become obsolete due to new technology or transitions in the enterprise's product lines.

Involuntary LIFO liquidations stem from reasons beyond the control of management, such as a strike, material shortages, shipping delays, etc. Whether voluntary or involuntary, all LIFO liquidations result in a corresponding increase in income in periods of rising prices.

To determine the effect of the liquidation, management 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 preceding example the effect of the year 3 LIFO liquidation would be computed as follows:

Hypothetically, if there had been an increment instead of a decrement in year 3 and the year 2 inventory layer had remained intact, 200 more units (out of the 300 total units sold in year 3) would have been charged to cost of goods sold at the year 3 price of $3.50 instead of the year 2 price of $3.20. Therefore, the difference between $3.50 and the actual amount charged to cost of sales for these 200 units liquidated ($3.20) measures the effect of the liquidation.

The following is considered acceptable GAAP disclosure in the event of a LIFO liquidation:

During 2013, inventory quantities were reduced below their levels at December 31, 2012. As a result of this reduction, LIFO inventory costs computed based on lower prior years' acquisition costs were charged to cost of goods sold. If this LIFO liquidation had not occurred and cost of sales had been computed based on the cost of 2013 purchases, cost of goods sold would have increased by approximately $xxx and net income decreased by approximately $xx or $x per share.

Applying the unit LIFO method requires a substantial amount of recordkeeping. The recordkeeping becomes more burdensome as the number of products increases. For this reason a “pooling” approach is often used to compute LIFO inventories.

Pooling is the process of grouping items that are naturally related and then treating this group as a single unit in determining LIFO cost. Because the ending inventory normally includes many items, decreases in one item can be offset by increases in others, whereas under the unit LIFO approach a decrease in any one item results in a liquidation of all or a portion of a LIFO layer.

Complexity in applying the pooling method arises from the income tax regulations. These regulations require that the opening and closing inventories of each type of good be compared. In order to be considered comparable for this purpose, inventory items must be similar as to character, quality, and price. This qualification has generally been interpreted to mean identical. The effect of this interpretation is to require a separate pool for each item under the unit LIFO method. To provide a simpler, more practical approach to applying LIFO and allow for increased use of LIFO pools, election of the dollar-value LIFO method is permitted.

Dollar-value LIFO. Dollar-value LIFO may be elected by any taxpayer. Under the dollar-value LIFO method of inventory valuation, the cost of inventories is computed by expressing base-year costs in terms of total dollars rather than specific prices of specific units. The dollar-value method also provides an expanded interpretation of the use of LIFO pools. Increments and decrements are treated the same as under the unit LIFO approach but are reflected only in terms of a net increment or liquidation for the entire pool.

Identifying pools. Three alternatives exist for determining pools under dollar-value LIFO: (1) the natural business unit method, (2) the multiple pooling method, and (3) pools for wholesalers, retailers, jobbers, and the like.

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 upon the type of product being produced, not the various stages of production for that product. Thus, the pool of a manufacturer can (and will) contain raw materials, WIP, and finished goods. The three examples below, adapted from the treasury regulations, illustrate the application of the natural business unit concept.

The treasury regulations require that a pool consist of all items entering into the entire inventory investment of a natural business unit, unless the taxpayer elects to use the multiple-pooling method.

The multiple-pooling method is the grouping of “substantially similar” items. In determining substantially similar items, consideration is 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 gross profit and periodic net income.

According to Reg. §1.472-8(c), inventory items of wholesalers, retailers, jobbers, and distributors are to be assigned to pools by major lines, types, or classes of goods. The natural business unit method may be used with permission of the Commissioner.

All three methods of pooling allow for a change in the components of inventory over time. New items which properly fall within the pool may be added, and old items may disappear from the pool, but neither will necessarily cause 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 priced at end-of-year prices to that same quantity of 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 computed at current year cost is divided by the appropriate index to arrive at its base-year cost. The main computational focus is on the determination of the conversion price index. There are four types of methods that can be used in the computation of the ending inventory amount of a dollar-value LIFO pool: (1) double-extension, (2) link-chain, (3) indexing, and (4) alternative LIFO for automobile dealers.

Double-extension method. This method was 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 “double-extension.” The dollar total computed at end-of-year prices is then divided by the dollar total computed at base-year prices 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 to 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 maintained for each inventory item. Depending upon the number of different items included in the inventory of the enterprise, the necessary records may be too detailed to keep past the first year or two.

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 LIFO inventory accounting.

Link-chain method. Since the double-extension method computations are arduous even if only a few items exist in the inventory, consider the complexity that arises when there is a constant change in the inventory mix or when there is a large number of inventory items. The link-chain method of applying dollar-value LIFO was developed to mitigate the effects of this complexity.

Consider the situation where the components of inventory are constantly changing. The regulations require that any new products added to the inventory be recorded at base-year prices. If these are not available, then the earliest cost available after the base year is used. If the item was not in existence in the base year, the taxpayer may 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. Finally, as a last resort, the current year purchase price can be used. While this does not appear to be a problem on the surface, imagine a base period that is twenty-five to fifty years in the past. The difficulty involved with finding the base-year cost may require using a more current cost, thus eliminating some of the LIFO benefit. Imagine a situation faced by a company in 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. When inventory has such a rapid turnover, the overall LIFO advantage becomes diluted as current and base-year costs are often identical. This situation necessitated the development of the link-chain method.

The link-chain method was originally developed for (and limited to) those companies that wanted to use LIFO but, because of a substantial change in product lines over time, were unable to reconstruct or maintain 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 elective alternatives for the same situation. For income tax purposes, the link-chain election requires that substantial changes in product lines be evident over the years, and may not be elected solely because of its ease of application. The double-extension and index methods must be demonstrably impractical in order to elect the link-chain method. However, an enterprise may use different computational techniques for financial reporting and income tax purposes. Therefore, the link-chain method could be used for financial reporting purposes even if a different application is used for income tax purposes. Obviously, the recordkeeping burdens imposed by using different LIFO methods for GAAP and income tax purposes (including the deferred income tax accounting that would be required for the temporary difference between the GAAP and income tax bases of the LIFO inventories) would make this a highly unlikely scenario.

The link-chain method is the process of developing a single cumulative index which is applied to the ending inventory amount priced using beginning-of-the-year costs. Thus, the index computed at the end of each year is “linked” to the index from all previous years. 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 accommodated by the method used to calculate each current year's index. The index is calculated by double-extending a representative sample of items in the pool at both beginning-of-year prices and end-of-year prices. This annual index is then applied to (multiplied by) the previous period's cumulative index to arrive at the new current year cumulative index.

An example of the link-chain method is shown below. The end-of-year costs and inventory quantities used are the same as those used in the double-extension 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 base-year prices, but perhaps more importantly, it is easier to establish beginning-of-the-year prices for new items than to establish their base-year price. This 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.

Indexing methods. 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. The regulations allow for the use of a statistically valid representative sample of the inventory to be double-extended. The 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, referred to in treasury regulations as the Inventory Price Index Computation (IPIC) Method, involves using indices published by the U.S. Department of Labor's Bureau of Labor Statistics (BLS)³ and applying them to specified categories of inventory included in the taxpayer's LIFO pools. Taxpayers wanting to change to the IPIC Method from another LIFO method must obtain IRS consent by filing Form 3115, Application for Change in Accounting Method.

Alternative LIFO method for automobile dealers. A simplified dollar-value method is available for use by retail automobile dealers for valuing inventory of new automobiles and light-duty trucks. The use of this method and its acceptance for income tax purposes is conditioned on the application of several LIFO submethods, definitions, and special rules. The reader is referred to Rev. Proc. 92-79 for a further discussion of this method.

LIFO accounting literature. GAAP for the application of LIFO has been based upon income tax rules rather than on financial accounting pronouncements. LIFO is cited in GAAP as an acceptable inventory method, but specific rules regarding its implementation are not provided. The income tax regulations, as discussed below, do provide specific rules for the implementation of LIFO and require financial statement conformity. For this reason, income tax rules have essentially defined the financial accounting treatment of LIFO inventories.

In recognition of the lack of authoritative accounting guidelines in the implementation of LIFO, the American Institute of Certified Public Accountants (AICPA)'s Accounting Standards Division formed a task force on LIFO inventory problems to prepare an Issues Paper on this topic. “Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories,” issued in 1984, identifies financial accounting issues resulting from the use of LIFO and includes advisory guidance on resolving them. Issues Papers, however, do not establish authoritative standards of financial accounting. The guidance provided by the task force is described below.⁴

1. Specific goods versus dollar-value. Either the specific goods approach or dollar-value approach to LIFO is acceptable for financial reporting. Disclosure of whether the specific goods or dollar-value approach is used is not required.
2. Pricing current year purchases. Three approaches to pricing LIFO inventory increments are available under income tax regulations—earliest acquisition price, latest acquisition price, and average acquisition price. The earliest acquisition price approach is the most compatible with financial reporting objectives, but all three are acceptable for financial reporting.
3. Quantity to use to determine price. The price used to determine the inventory increment should be based on the cost of the quantity or dollars of the increment rather than on the cost of the quantity or dollars equal to the ending inventory. Disclosure of which approach is used is not required.
4. Disclosure of LIFO reserve or replacement cost. The LIFO reserve or replacement cost and its basis for determination should be disclosed for financial reporting.
5. Partial adoption of LIFO. If a company changes to LIFO, it should do so for all of its inventories. Partial adoption should only be allowed if there exists a valid business reason for not fully adopting LIFO. A planned gradual adoption of LIFO over several time periods is considered acceptable if valid business reasons exist (lessening the income statement effect of adoption in any one year is not a valid business reason). Where partial adoption of LIFO has been justified, the extent to which LIFO has been adopted should be disclosed. This can be disclosed by indicating either the portion of the ending inventory priced on LIFO or the portion of cost of sales resulting from LIFO inventories.
6. Methods of pooling. An entity should have valid business reasons for establishing its LIFO pools. Additionally, the existence of a separate legal entity that has no economic substance is not reason enough to justify separate pools. Disclosure of details regarding an entity's pooling arrangements is not required.
7. New items entering a pool. New items should be added to a pool based on what the items would have cost had they been acquired in the base period (reconstructed cost) rather than based on their current cost. The reconstructed cost should be determined based on the most objective sources available, including published vendor price lists, vendor quotes, and general industry indexes. Where necessary, the use of a substitute base year in making the LIFO computation is acceptable. Disclosure of the way that new items are priced is not required.
8. Dollar-value index. The required index can be developed using two possible approaches, the unit cost method or the cost component method. The unit cost method measures changes in the index based on the weighted-average increase or decrease in the unit costs of raw materials, work-in-process, and finished goods inventory. The cost component method, on the other hand, measures changes in the index by the weighted-average increase or decrease in the component costs of material, labor, and overhead that make up ending inventory. Either of these methods is acceptable.
9. LIFO liquidations. The effects on income of LIFO inventory liquidations should be disclosed in the notes to the financial statements. A replacement reserve for the liquidation should not be provided. When an involuntary LIFO liquidation occurs, the effect on income of the liquidation should not be deferred.

   When a LIFO liquidation occurs, there are three possible ways to measure its effect on income:

   1. The difference between actual cost of sales and what cost of sales would have been had the inventory been reinstated under the entity's normal pricing procedure
   2. The difference between actual cost of sales and what cost of sales would have been had the inventory been reinstated at year-end replacement cost
   3. The amount of the LIFO reserve at the beginning of the year which was credited to income (excluding the increase in the reserve due to current year price changes).

   The first method is considered preferable. Disclosure of the effect of the liquidation should give effect only to pools with decrements (i.e., there should be no netting of pools with decrements against other pools with increments).

10. Lower of cost or market. The most reasonable approach to applying the lower of cost or market rules to LIFO inventory is to base the determination on groups of inventory rather than on an item-by-item approach. A pool constitutes a reasonable grouping for this purpose. An item-by-item approach is permitted by authoritative accounting literature, particularly for obsolete or discontinued items.

    For companies with more than one LIFO pool, it is permissible to aggregate the pools in applying the lower of cost or market test if the pools are similar. Where the pools are significantly dissimilar, aggregating the pools is not appropriate.

    Previous write-downs to market value of the cost of LIFO inventories should be reversed after a company disposes of the physical units of the inventory for which reserves were provided. The reserves at the end of the year should be based on a new computation of cost or market.

11. LIFO conformity and supplemental disclosures. A company may present supplemental non-LIFO disclosures within the historical cost framework. If nondiscretionary variable expenses (i.e., profit sharing based on earnings) would have been different based on the supplemental information, then the company should give effect to such changes. Additionally, the supplemental disclosure should reflect the same type of income tax effects as required by generally accepted accounting principles in the primary financial statements.

    A company may use different LIFO applications for financial reporting than it uses for income tax purposes. Any such differences should be accounted for as temporary differences with the exception of differences in the allocation of cost to inventory in a business combination. Any differences between LIFO applications used for financial reporting and those used for income tax purposes need not be disclosed beyond the requirements of ASC 740.

12. Interim reporting and LIFO. The FASB guidance on interim reporting of LIFO inventory is discussed in the Chapter on ASC 270.
13. Different financial and income tax years. A company with different fiscal year-ends for financial reporting and income tax reporting should make a separate LIFO calculation for financial purposes using its financial reporting year as a discrete period for that calculation.
14. Business combinations accounted for by the purchase method. Inventory acquired in a business combination accounted for by the purchase method will be recorded at fair value at the date of the combination. The acquired company may be able to carry over its prior basis for that inventory for income tax purposes, causing a difference between GAAP and income tax basis. An adjustment should be made to the fair value of the inventory only if it is reasonably estimated that it will be liquidated in the future. The adjustment would be for the income tax effect of the difference between income tax and GAAP basis.

    Inventory acquired in such a combination should be considered the LIFO base inventory if the inventory is treated by the company as a separate business unit or a separate LIFO pool. If instead the acquired inventory is combined into an existing pool, then the acquired inventory should be considered as part of the current year's purchases.

15. Changes in LIFO applications. A change in a LIFO application is a change in accounting principle. LIFO applications refer to the approach (i.e., dollar value or specific goods), computational technique, or the numbers or contents of the pools.

ASC 810-10-55 provides guidance for intercompany transfers. The focus of this section is the LIFO liquidation effect caused by transferring inventories, which in turn creates intercompany profits. This liquidation can occur when (1) two components of the same taxable entity transfer inventory, for example, when a LIFO method component transfers inventory to a non-LIFO component, or (2) when two separate taxable entities that consolidate transfer inventory, even though both use the LIFO method.

This LIFO liquidation creates profit that must be eliminated along with other intercompany profits.

LIFO income tax rules and restrictions. As discussed previously, most of the rules and regulations governing LIFO originate in the U.S. IRC and the related regulations, revenue rules, revenue procedures, and judicial decisions. Taxpayers electing to use the LIFO inventory method are subject to myriad rules and restrictions, such as:

1. The inventory is to be valued at cost regardless of market value (i.e., application of the lower of cost or market rule is not allowed).
2. Changes in the LIFO reserve can potentially cause the taxpayer to be subject to alternative minimum tax (AMT) or increase the amount of AMT.
3. Corporations that use the LIFO method whose stockholders subsequently elect to be taxed as an “S” Corporation are required to report as income their entire LIFO reserve resulting in a special tax under IRC §1363(d) that is payable in four annual installments. The “S” Corporation is, however, permitted to retain LIFO as its inventory accounting method after the election.
4. Once elected, the LIFO method must continue to be used consistently in future periods. A taxpayer is permitted, subject to certain restrictions, to revoke its LIFO election in accordance with Rev. Proc. 99-49. After revocation however, the taxpayer is precluded from reelecting LIFO for a period of five taxable years beginning with the year of the change. For GAAP purposes, a change to or from the LIFO method is accounted for as a change in accounting principle under ASC 250.

A unique rule regarding LIFO inventories is referred to as the LIFO Conformity Rule. A taxpayer may not use a different inventory method in reporting profit or loss of the entity for external financial reports. Thus, if LIFO is elected for income tax purposes, it must also be used for accounting purposes.

Treasury regulations permit certain exceptions to this general rule. Among the exceptions allowable under the regulations are the following:

1. The use of an inventory method other than LIFO in presenting information reported as a supplement to or explanation of the taxpayer's primary presentation of income in financial reports to outside parties. (Reg. §1.472-2[e][1][i])
2. The use of an inventory method other than LIFO to determine the value of the taxpayer's inventory for purposes of reporting the value of such inventory as an asset on the statement of financial position. (Reg. §1.472-2[e][1][ii])
3. The use of an inventory method other than LIFO for purposes of determining information reported in internal management reports. (Reg. §1.472-2[e][1][iii])
4. The use of an inventory method other than LIFO for financial reports covering a period of less than one year. (Reg. §1.472–2[e][1][iv])
5. The use of lower of LIFO cost or market to value inventories for financial statements while using LIFO cost for income tax purposes. (Reg. §1.472-2[e][1][v])
6. For inventories acquired by a corporation in exchange for issuing stock to a stockholder that, immediately after the exchange, is considered to have control (a section 351 transaction), the use of the transferor's acquisition dates and costs for GAAP while using redetermined LIFO layers for tax purposes. (Reg. §1.472-2[e][1][vii])
7. The inclusion of certain costs (under full absorption) in inventory for income tax purposes, as required by regulations, while not including those same costs in inventory under GAAP (full absorption). (Reg. §1.472-2[e][8][i])
8. The use of different methods of establishing pools for GAAP purposes and income tax purposes. (Reg. §1.472-2[e][8][ii])
9. The use of different determinations of the time sales or purchases are accrued for GAAP purposes and tax purposes. (Reg. §1.472-2[e][8][xii])
10. In the case of a business combination, the use of different methods to allocate basis for GAAP purposes and income tax purposes. (Reg. §1.472-29[e][8][xiii])

Another important consideration in applying the LIFO conformity rule is the law concerning related corporations. In accordance with the Tax Reform Act of 1984, all members of the same group of financially related corporations are treated as a single taxpayer when applying the conformity rule. Previously, taxpayers were able to circumvent the conformity rule by having a subsidiary on LIFO, while the non-LIFO parent presented combined non-LIFO financial statements. This is a violation of the conformity requirement [Sec. 472(g)].

The LIFO conformity rule is viewed as a major obstacle to the adoption of International Financial Reporting Standards (IFRS) in the United States. Since IFRS does not permit the use of LIFO for valuing inventories, should a U.S. taxpayer convert from U.S. GAAP to IFRS in presenting its basic financial statements, that taxpayer would violate the LIFO conformity rule, which would result in an automatic revocation of the LIFO election. Thus, the adoption of IFRS would likely cause a heavy income tax burden for those taxpayers using LIFO to value their inventories.

Weighted-Average and Moving-Average

Another method of inventory valuation involves averaging and is commonly referred to as the weighted-average method.

Under this method the cost of goods available for sale (beginning inventory plus net purchases) is divided by the number of units available for sale to obtain a weighted-average cost per unit. Ending inventory and cost of goods sold are then priced at this average cost.

This method is permitted for financial reporting purposes but had historically been prohibited for income tax purposes. (Rev. Ruling 71-234) The IRS has issued Revenue Procedure 2008-43, which grants limited use of this method for income tax reporting purposes. This relief is only available to taxpayers that were already using an average cost method for financial reporting purposes. In addition, an electing taxpayer is required to meet both of the following safe harbors:

1. The taxpayer must recompute the rolling average inventory price with every new purchase, or no less frequently than monthly.
2. The results under the rolling average method may not vary by more than 1% from the results using a FIFO or specific identification method. A shortcut method is permitted to be used to meet this safe harbor. If the taxpayer's annual turnover for its entire inventory exceeds four times, this safe harbor is considered to have been met.

Comparison of Cost Flow Assumptions

Of the three cost flow assumptions, FIFO and LIFO produce the most extreme results, while results from using the weighted-average method generally fall somewhere in between. The selection of one of these methods involves a detailed analysis of the organization's objectives, industry practices, current and expected future economic conditions, and most importantly, the needs of the intended users of the financial statements.

The following table compares the relative effects of using FIFO and LIFO cost assumptions on the statement of financial position and statement of income under differing economic conditions:

In periods of rising prices, the LIFO method is generally thought to best fulfill the objective of providing the clearest measure of periodic net income. It does not, however, provide an accurate estimate of inventory cost in an inflationary environment. However, this shortcoming can usually be overcome by providing additional disclosures in the notes to the financial statements. In periods of rising prices, a prudent business should use the LIFO method because it will result in a decrease in the current income tax liability when compared to other alternatives. In a deflationary period, the opposite is true.

FIFO is a balance-sheet-oriented costing method. It gives the most accurate estimate of the current cost of inventory during periods of changing prices. In periods of rising prices, the FIFO method will result in higher income taxes than the other alternatives, while in a deflationary period FIFO provides for a lesser income tax burden. However, a major advantage of the FIFO method is that it is not subject to all of the complex regulations and requirements of the income tax code that govern the use of LIFO.

The average methods do not provide an estimate of current cost information on either the statement of financial position or income statement. The average methods are not permitted to be used for income tax purposes and therefore, their use for financial reporting purposes would necessitate the use of FIFO for income tax reporting purposes since LIFO requires financial statement conformity.

Although price trends and underlying objectives are important to consider in selecting a cost flow assumption, other considerations are the risk of experiencing unintended liquidations of LIFO layers, as well as the effects of the chosen method on cash flow, capital maintenance, collateral requirements, and restrictive covenants imposed by lenders, etc.

Inventory Estimation Methods

There are instances in which an accountant must estimate the value of inventories without an actual physical count. Some of the estimation methods used to accomplish this are the retail method, the LIFO retail method, and the gross profit method. These methods are not cost flow assumptions like LIFO and FIFO; rather, they are computational methods that have been devised to assist in estimating inventory cost under the relevant cost flow assumption.

Retail method. The retail method is used by retailers 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 a computed cost-to-retail ratio to convert the ending inventory priced at retail to its estimated cost. This method eliminates the process of going back to original vendor invoices or other documents in order 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 is also applied when either one of these two cost assumptions is used in conjunction with the retail method.

The key to applying the retail method is determining the cost-to-retail ratio. The calculation of this ratio varies depending upon the cost flow assumption selected. The cost-to-retail ratio provides a measure of the relationship between the cost of goods available for sale and the retail price of these same goods. This ratio is used to convert the ending retail inventory back to cost. The computation of the cost-to-retail ratio for the FIFO and average cost methods is described below. The use of the LIFO cost flow assumption with this method is discussed in the succeeding section.

1. FIFO cost—The FIFO method assumes that the ending inventory is made up of the latest purchases. Therefore, beginning inventory is excluded from the computation of the cost-to-retail ratio, and the computation uses the cost of current year net purchases divided by their retail value adjusted for both net markups and net markdowns as will be further explained and illustrated.
2. FIFO (LCM)—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 (LCM)—Is computed in the same manner as average cost, except that markdowns are excluded from the calculation of the cost-to-retail ratio.

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” pricing is achieved by including net markups but excluding net markdowns, from the cost-to-retail ratio.

To understand this approximation, assume 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). The logic behind including markdowns in the cost-to-retail ratio is the assumption that these inventories would eventually be marked down and that markdowns are a normal part of business for this enterprise and/or these types of inventories. 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 (LCM). The logic behind excluding markdowns from the cost-to-retail ratio is that the enterprise did not expect to mark these inventory items down and that this is not a normal occurrence. The write-down to $4.80 reflects the loss in utility which 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 previous example, both would have been included in the cost-to-retail ratio.

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

There are a number of additional issues that affect the computation of the cost-to-retail ratio. Purchase discounts and freight-in 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. Sales discounts are not included in the computation. If sales are recorded gross, then deduct the gross sales figure. If sales are recorded net, then both the recorded sales and sales discount must be deducted to give the same effect as deducting gross sales. Normal spoilage is generally allowed for in the enterprise's pricing policies, and for this reason it is deducted from the retail column after the calculation of the cost-to-retail ratio. Abnormal spoilage, on the other hand, is deducted from both the cost and retail columns before the cost-to-retail calculation as it could otherwise distort the ratio. It is then generally reported as a separate loss, either within cost of goods sold or administrative expenses. Abnormal spoilage generally arises from a major theft or casualty, while normal spoilage is usually due to shrinkage or breakage. These determinations and their treatments will vary depending upon the enterprise's policies.

When applying the retail method, separate computations are made for any departments that experience significantly higher or lower gross profit margins. Distortions arise in applying the retail method when a department sells goods with gross profit margins that vary in a proportion different from the gross profit margins of goods purchased during the period. In this 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 estimating inventories under FIFO (LCM) for income tax purposes. Income tax regulations require valuation at lower of cost or market (except for LIFO) and regular and consistent physical counts of inventory at each location.

LIFO retail method. As with other LIFO methods, treasury regulations are the governing force behind the LIFO retail method. The regulations differentiate between a “variety” store, which is required to use an internally computed index, and a “department” store, which is permitted to use a price index published by the Bureau of Labor Statistics. The computation of an internal index was previously discussed in the dollar-value LIFO section. It involves applying the double-extension method to a representative sample of the ending inventory. Selection of an externally published index is to be in accordance with the Treasury regulations.

The steps used in computing the value of ending inventory under the LIFO retail method are listed below and then applied in 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, income tax regulations do not permit the use of LCM, so both markups and markdowns are included in the 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. Divide the current ending inventory at retail by the current year index determined in Step 1.
4. Layers are then treated 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 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 taken. It can also be used to evaluate the reasonableness of a given inventory amount. Assume the following data:

Ending inventory is estimated as follows:

The gross profit method is used for interim reporting estimates, for conducting analytical review procedures by independent accountants in audits and review engagements, and for estimating inventory lost in fires or other catastrophes. The method is not acceptable, however, for either income tax or annual financial reporting purposes.

Standard costs. Standard costs are predetermined unit costs used by manufacturing firms for planning and control purposes. Standard costs are often used to develop approximations of GAAP inventories for financial reporting purposes. The use of standard cost approximations in financial reporting is acceptable only if adjustments to the standards are made periodically to reflect current conditions and if their use approximates the results that would be obtained by directly applying one of the recognized cost flow assumptions.

Other Inventory Valuation Methods

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, since it is not allowed for income tax purposes, and the LIFO method yields similar results.

Direct costing. An alternative to full absorption costing is direct costing. Direct costing (also referred to as variable costing) requires classifying only direct materials, direct labor, and variable production overhead as inventory costs. Under this method, all fixed costs are accounted for as period costs. The exclusion of all overhead from inventory costs is not an acceptable accounting method for GAAP or under the U.S. Treasury Regulations for income tax purposes.

Relative sales value. Relative sales (or net realizable) values are used to assign costs to inventory items purchased or manufactured in groups. This method is applicable to joint products, subdivided assets such as real estate lots, and basket purchases.

For example, products A and B have the same processes performed on them up to the split-off point. The total cost incurred to this point is $80,000. This cost can be assigned to products A and B using their relative sales value at the split-off point. If A could be sold for $60,000 and B for $40,000, the total sales value is $100,000. The cost would be assigned on the basis of each product's relative sales value. Thus, A would be assigned a cost of $48,000 (60,000/100,000 × 80,000) and B a cost of $32,000 (40,000/100,000 × 80,000).

Full Absorption Costing—Income Tax

The Tax Reform Act (TRA) of 1986 included provisions referred to as Uniform Capitalization (UNICAP) requiring certain additional indirect costs that are not capitalizable under GAAP to be capitalized rather than expensed for income tax purposes.

1. Depreciation and amortization in excess of that reported in financial statements
2. Percentage depletion in excess of cost
3. Rework labor, scrap, and spoilage costs
4. Allocable general and administrative costs related to the production function.

For income tax purposes, these costs, as well as the indirect production costs listed above for inventory costing under GAAP, are allocated to the WIP and finished goods inventories. Examples of general and administrative costs that must be allocated include payroll department costs, wages of security guards, and the president's salary. The difference between the GAAP and income tax inventory carrying values is a temporary difference, which requires deferred income tax accounting (discussed in Chapter 24).

Uniform Capitalization Rules—Income Tax versus GAAP

TRA 1986 established the UNICAP rules for inventory costs for tax purposes. ASC 330-10-55-4 states that capitalizing a cost for income tax purposes does not, by itself, indicate that it is preferable or even appropriate to capitalize the cost for financial reporting purposes. Although a cost may be required to be capitalized for income tax purposes, management must analyze the individual facts and circumstances based on the nature of its operations and industry practice to determine whether to capitalize the cost for financial reporting purposes.

Inventory Capitalization for Retailers/Wholesalers—Income Tax versus GAAP

TRA 1986 applied UNICAP to certain retailers and wholesalers and introduced a requirement that additional costs be capitalized. Inventories of retailers/wholesalers whose average annual gross receipts for the preceding three years are $10 million or less are exempt from applying UNICAP.

The costs which must be capitalized have been divided into two categories. The first category is direct costs and includes the inventory invoice price plus transportation. Also included in direct costs is the cost of labor for purchasing, storing, and handling inventory items. The second category is indirect costs and consists of any costs that directly benefit or are incurred because of the performance of a resale activity. The following types of indirect costs must be capitalized under UNICAP:

1. Off-site storage or warehousing
2. Purchasing
3. Handling, processing, assembly, and repackaging
4. Allocable general and administrative costs related to the above three functions.

The indirect costs are allocated between inventory and cost of goods sold by using traditional methods (specific identification, standard costing methods, etc.) or one of three simplified methods. Temporary differences require deferred income tax accounting as discussed in the chapter on ASC 740, Income Taxes.

Purchase Commitments

Purchase commitments generally are not recognized in the financial statements because they are executory in nature. However, disclosure in the notes to the financial statements is required for firm purchase commitments that are material in amount.

If at the date of a statement of financial position the contract price of these commitments exceeds the market value, the estimated loss is accrued and reported as a loss in the income statement. This results in recognition of the loss before the inventory is actually purchased.

Inventories Valued at Selling Price

In exceptional cases, inventories may be reported at sales price less estimated disposal costs. Such treatment is justified when cost is difficult to determine, quoted market prices are available, marketability is assured, and units are interchangeable. Precious metals, certain agricultural products, and meat are examples of inventories valued in this manner. When inventory is valued above cost, revenue is recognized before the time of sale. Naturally full disclosure in the financial statements is required.

Stripping Costs Incurred During Production in the Mining Industry

ASC 930-330 states that stripping costs incurred during a mine's production phase are to be accounted for as variable production costs and therefore allocated to inventory. The ASC is limited to stripping costs incurred during the period when inventory is being produced (i.e., extracted) and did not address the accounting for these costs when incurred during the preproduction phase of the mine.

Interim Reporting

For a complete discussion of interim financial reporting see the chapter on ASC 270.