An alternative approach for computing dollar-value LIFO.

Introduction

Regulation 1.472-8 of the Internal Revenue Code allows companies to report their inventory u.sing the "dollar-value" LIFO method. Generally, accountants value current inventory at base-year costs to determine additional increases or decreases in the inventory layers. This paper presents an alternative approach for determining the dollar-value LIFO layers to be included in a company's reported amount for inventory. In this approach, layers are determined based upon current year-end price levels rather than upon base-year prices. This alternative approach reduces the number of calculations accountants make when determining the value of year-end inventory, using the dollar-value LIFO method.

The Treasury Regulations allow accountants to value inventory and cost of goods sold using the LIFO (last-in, first-out) method. Companies who use the LIFO method for tax purposes must also use that method for financial accounting purposes. One computational method of determining LIFO is the dollar-value LIFO method.(1) This method values inventory layers at costs expressed in dollars rather than in units of items. Accountants tend to use the "base-year" approach to calculate dollar-value LIFO in which the current inventory cost is revalued at base-year costs to determine changes in the inventory layers. An alternative approach to determining the inventory increments and total inventory value can be utilized. This alternative approach computes the inventory increments using current-year costs, rather than the base-year costs. This method of computing dollar-value LIFO requires fewer computations.

Traditional approach based upon base-year prices

Using the base-year approach, ending inventory and all previously existing inventory layers are converted to amounts based upon a base-year price level. Increases in inventory amounts stated at base-year prices add a new layer. This new layer must then be converted back to current year-end prices. This method of computing dollar-value LIFO requires numerous computations to determine the value of incremental layers to the inventory pools and the total value of inventory. Although accountants may use the base-year price level as the common price level, the use of the base-year is not a requisite for applying dollar-value LIFO.

Alternative approach based upon current year-end prices

An alternate approach to computing dollar-value LIFO uses the price level at the end of a given year (i.e., the current-year) as the common price level. Table 1 provides costs of ending inventory and the related price indices for the years 1990 through 1994, which will be used in the following discussion. Assume a company begins using dollar-value LIFO at the end of 1990. Inventory of $20,000 is determined based upon prices in existence at the end of 1990. The price level index equals 100 in the year dollar-value LIFO is adopted. Next, assume that prices increased five percent in 1991 as compared to 1990. That is, inventory prices at the end of 1991 were 105 percent of the prices at the end of 1990. Further, suppose that, based on a physical count of the inventory on December 31, 1991, the inventory cost amounts to $23,100 based upon 1991 year-end prices. This 1991 ending inventory, with a value of $23,100 at 1991 year-end prices, must be allocated between the existing 1990 layer at 1990 year-end prices and a new 1991 layer at 1991 year-end prices.

TABLE 1

Summary Data

               ENDING
               INVENTORY
               AT CURRENT-      PRICE
YEAR           YEAR PRICES      INDEX

1990             $20,000        1.00
1991             $23,100        1.05
1992             $27,250        1.09
1993             $27,600        1.15
1994             $32,400        1.20

Source: Hartman, et al. (1995, 447)

[TABULAR DATA FOR TABLE 2 OMITTED]

As shown in Table 2, last year's ending inventory at last year's ending prices (which is NOT the reported amount for inventory in the accounting records after the year of adoption) can be converted to this year's ending prices using the ratio of this year's ending price level (numerator) to last year's ending price level (denominator). The conversion thus expresses beginning inventory at year-end prices. Incremental layers to the LIFO pool are determined by comparing the restated beginning inventory to the ending inventory, both stated in current-year dollars. This technique requires a single conversion.

For example, at the end of 1991, the prior year's ending inventory ($20,000) is converted to current-year costs when the price index is 105. The beginning inventory, stated at the 1991 year-end price level, is $21,000. This amount is then compared to the 1991 year-end price for ending inventory of $23,100 to determine the incremental layer in the inventory pool of $2,100. Because LIFO maintains the older costs in inventory, the 1990 layer must remain at the 1990 year-end price of $20,000. The reported amount of dollar-value inventory for December 31, 1991 is comprised of the two layers, the $20,000 (1990 layer) and the $2,100 (1991 layer). The total reported inventory is $22,100.

The traditional approach converts ending inventory and all layers to base-year prices, instead of converting beginning inventory to current year-end prices. Using the traditional base-year approach, for 1991 the year-end price for ending inventory of $23,100 would have a cost of $22,000 at base-year prices ($23,100 x 100/105). When compared to the $20,000 existing layer, an incremental layer for 1991, of $2,000 at base-year prices, results. However, another conversion is necessary to express the new incremental layer at the cost of inventory when the layer is added, which is current year-end prices. That is, the reported amount for the 1991 layer is $2,100 ($2,000 X 105/100), instead of the base-year amount of $2,000. This latter conversion is not necessary when using the alternative approach since amounts are already expressed in current year-end prices.

Returning to the current-year approach as shown in Table 2, consider 1992. As determined for the 1991 year-end, the first two layers (1990 and 1991) would have cost $23,100 when prices were at the 1991 price level of 105 percent. This $23,100 in 1991 year-end prices would cost $23,980 (i.e., $23,100 x 109/105) at the end of 1992 when prices are at the 109 percent level. Note the operational efficiency for determining 1992's beginning inventory cost at 1992 year-end prices. Comparing the converted beginning inventory ($23,980) to the 1992 ending inventory, of $27,250 at year-end prices, adds another layer of $3,270.

Decreases in inventory layers begin with the most recent layer. Because the layers are stated at their original prices, any layer reductions are based upon the respective layer's price level. In the example, the 1992 ending inventory is converted to 1993 year-end prices. This restated cost of beginning inventory, $28,750, compared to the ending inventory of $27,600 reflects a decrease in inventory of $1,150. This decrease must be converted to the price level of the most recent layer to determine the reduction of the prior layer. Therefore the decrease of $1,150 is converted back to 1992 prices ($1,150 x 109/115) to determine that the 1992 incremental layer is reduced by $1,090. Once any prior layer (or portion thereof) is removed, it is not replaced at a later date, so the remaining 1992 layer for future years is $2,180. Had the 1992 layer been less than $1,090, it would be completely eliminated and any further reductions would be based upon the 1991 layer using its price level of 105.

Table 3 shows an extended version for applying the alternative approach of computing dollar-value LIFO. As shown in the table, each layer of the inventory pool is converted to current cost using the ratio of this year's ending price level (numerator) to the price level of the related layer (denominator). These converted amounts are summed to provide the current cost of beginning inventory which is compared to the current year ending inventory to determine incremental increases or decreases. This approach would be used when the total value of last year's ending inventory at last year's year-end prices is unknown.

First, the 1991 beginning inventory, which cost $20,000 at the end of 1990, is converted to 1991 year-end prices ($20,000 x 1.05 or 105/100). The ending inventory of $23,100, based upon ending 1991 prices, represents an increase of $2,100 (i.e., $23,100-$21,000) as the 1991 layer. The reported amount of dollar-value inventory for December 31, 1991 is comprised of the two layers: $20,000 (1990 Layer) + $2,100 (1991 Layer), for a total of $22,100.

[TABULAR DATA FOR TABLE 3 OMITTED]

At the end of 1992, when the price level is 109 percent of the 1990 prices, each of the prior layers are converted to 1992 prices to determine the value of the beginning inventory. The 1990 layer, which cost $20,000 at the end of 1990, would cost $21,800 (i.e., $20,000 x 109/100) at the end of 1992. Since the 1991 year-end prices were 105 percent of the 1990 year-end prices, the 1992 year-end prices are 109 percent/105 percent = 103.8 percent of 1991 year-end prices. Thus, the 1991 layer, which cost $2,100 at the end of 1991, would cost $2,180 (i.e., $2,100 x 109/105) at the end of 1992.

In total, then, the beginning inventory for 1992 would cost $23,980 (i.e., $21,800 + $2,180) when converted to the price level at the end of 1992. Comparing an actual ending inventory of $27,250, determined using 1992 year-end prices, to the beginning inventory, converted to 1992 year-end prices, indicates that the inventory increased $3,270. This increase is the 1992 layer.

Included in Table 3 is the LIFO liquidation or reduction for 1993. based upon 1993 year-end prices, inventory decreased $1,150. The reduction to reported inventory is $1,090 (i.e., $1,150 x 109/115) based upon 1992 year-end prices, the most recent layer. The reduction results in a remaining 1992 layer of $2,180.

Use of either of the two approaches results in the same amounts for the LIFO layers and total inventory value under the current-year method of computing dollar-value LIFO. For any given year, the current year-end price level for that year is the common price level. The beginning inventory is converted to year-end prices and compared to ending inventory, which was determined using the same year-end prices. Any increase is a new layer at the current year-end price level. A decrease reduces previously existing layers and is converted to price levels associated with the prior layers. As with the base-year approach to computing dollar-value LIFO, records should be kept of the ending inventory amount and price level used the previous year.

Conclusion

Computing dollar-value LIFO, by considering the current year-end cost of beginning inventory, is conceptually appealing. Accountants use current cost information to make many financial and operating decisions and would likely find current costs to be more relevant than base-year costs which may have existed many years previously. The use of the current-year cost approach may also reduce the time and effort required in computing the dollar-value LIFO inventory value. The alternative method of computing dollar-value lifo, described in this paper, requires only one conversion computation to determine the current year incremental layer, as shown in Table 2. Using the base-year approach, multiple computations are required to convert current year inventory to base-year costs and then to convert the incremental layer back to current year costs. Thus, to better utilize their time and efforts, accountants should consider computing dollar-value LIFO using the current-year cost approach.

1 In a study by Reeve and Stanga (1987), most companies using the LIFO method use either the dollar-value method or the dollar-value retail method to determine LIFO.

References

Hartman, B., R. Harper, J. Knoblett, and P. Reckers. 1995. Intermediate Accounting. Minneapolis/St. Paul, MN: West Publishing Company.

Reeve, J. M. and K. G. Stanga. 1987. The LIFO pooling decision. Accounting Horizons, (June) pp. 25-32.

United States Treasury Department. 1997. Income Tax Regulations, Volume 3 Chicago: CCH Incorporated.

Robert M. Harper, Jr. is the Department Chair for the Department of Accountancy in the Sid Craig School of Business at California State University, Fresno. A professor at Fresno State since 1990, Professor Harper was previously a faculty member at Louisiana State University. Dr. Harper received a BS in mathematics, an MBA and a DBA, all from Florida State University. He is a co-author of Intermediate Accounting, by South- Western College Publishing. Professor Harper has also published numerous articles in such journals as Journal of Accounting Research, Accounting Horizons, Behavioral Research in Accounting, Auditing: A Journal of Theory and Practice, Journal of Information Systems, and Journal of Accounting Education.

Denise M. Patterson is an Associate Professor in the Department of Accountancy in the Sid Craig School of Business at California State University. Professor Patterson received her BS degree from Stetson University, an MBA from the University of Central Florida and a PhD from Georgia State University. She is a CPA in the state of Florida. Dr. Patterson has published articles in the Journal of Business Ethics, Risk Management, and Accounting Horizons.