Problems with Applying LIFO

9.3 Problems with Applying LIFO

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

Recognize that theoretical and practical problems with LIFO have led the creators of IFRS rules to prohibit its use.
Explain that the most obvious problem associated with LIFO is an inventory balance that can show costs from years (or even decades) earlier, costs that are totally irrelevant today.
Identify the cause of a LIFO liquidation and the reason that it is viewed as a theoretical concern by accountants.

Reporting Ending Inventory Using LIFO

Question: As a result of the LIFO conformity rule in the tax laws, this cost flow assumption is widely used in the United States. LIFO, though, is not allowed in many other areas of the world. It is not simply unpopular in those locations; its application is strictly forbidden by IFRS. Thus, international companies are often forced to resort to alternatives in reporting their foreign subsidiaries. For example, a note to the 2010 financial statements of American Biltrite Inc. explains that “cost is determined by the last-in, first-out (LIFO) method for approximately 47% of the Company’s domestic inventories. The use of LIFO results in a better matching of costs and revenues. Cost is determined by the first-in, first-out (FIFO) method for the Company’s foreign inventories.”

Why is LIFO not accepted in most countries outside the United States?

Answer: Although LIFO can be supported as providing a better matching of expenses (cost of goods sold) with revenues, a number of serious problems arise from its application. The most common accusation made against LIFO is that it often presents a balance sheet figure that is out-of-date and completely useless. When applying this assumption, the latest costs are moved to cost of goods sold so that earlier costs remain in the inventory account—possibly for years and even decades. After some period of time, this asset balance is likely to report a number that has no relevance to today’s prices.

For example, in its 2010 financial statements, ExxonMobil reported inventory on its balance sheet of approximately $13.0 billion based on applying the LIFO cost flow assumption. In the notes to those financial statements, the company disclosed that the current cost to acquire this same inventory was actually $21.3 billion higher than the number being reported. The asset was shown as $13.0 billion but the price to obtain that merchandise on the balance sheet date was $34.3 billion ($13.0 billion plus $21.3). What is the possible informational value of reporting an asset (one that is being held for sale) at an amount more than $21 billion below its current replacement cost?As will be seen in the next chapter, similar arguments are made in connection with property and equipment—the reported amount and the value can vary greatly. However, those assets are not normally held for resale purpose so that their current worth is of less interest to decision makers. That is the essential problem attributed to LIFO.

To illustrate, assume that a convenience store begins operations and has a tank that holds ten thousand gallons of gasoline. On January 1, 1972, the tank is filled at a cost of $1 per gallon. Almost immediately the price of gasoline jumps to $2 per gallon. During the remainder of 1972, the store buys and sells gas. The tank is filled one final time at the very end of the year bringing total purchases to one million gallons. The first 10,000 gallons were bought at $1.00 per gallon; the next one million gallons cost $2.00 per gallon.

LIFO and FIFO report these results as follows:

LIFO
Cost of Goods Sold—1,000,000 gallons at last cost of $2 per gallon	$2,000,000
Ending Inventory—10,000 gallons at first cost of $1 per gallon	10,000

FIFO
Cost of Goods Sold—first 10,000 gallons at $1 per gallon and next 990,000 gallons at $2 per gallon	$1,990,000
Ending Inventory—10,000 gallons at last cost of $2 per gallon	20,000

After just this initial period, the ending inventory balance shown for LIFO (10,000 gallons at $1 per gallon) already differs significantly from the current cost of $2 per gallon.

If this convenience store continues to finish each year with a full tank of 10,000 gallons (certainly not an unreasonable assumption), LIFO will report this inventory at $1 per gallon for the following decades regardless of current prices. The most recent costs get transferred to cost of goods sold every period leaving the first costs ($1 per gallon) in inventory. The tendency to report this asset at a cost expended years in the past is the single biggest reason that LIFO is viewed as an illegitimate cost flow assumption in many countries. That same sentiment would probably exist in the United States except for the LIFO conformity rule.

Test Yourself

Question:

The Lenoir Corporation sells paperback books and boasts in its ads that it holds over one million volumes. Prices have risen over the years and, at the present time, books like those obtained by Lenoir cost between $4 and $5 each. Sandy Sanghvi is thinking about buying shares of the ownership stock of Lenoir and picks up a set of financial statements to help evaluate the company. The inventory figure on the company’s balance sheet is reported as $832,000 based on the application of LIFO. Which of the following is Sanghvi most likely to assume?

Lenoir has many subsidiaries in countries outside of the United States.
Lenoir officials prefer to minimize tax payments rather than looking especially healthy in an economic sense.
Lenoir’s net income is likely to be slightly inflated because of the impact of inflation.
Lenoir is likely to use different cost flow assumptions for financial reporting and income tax purposes.

Answer:

The correct answer is choice b: Lenoir officials prefer to minimize tax payments rather than looking especially healthy in an economic sense.

Explanation:

Knowledge of financial accounting provides a decision maker with an understanding of many aspects of the information reported by a company. Here, the inventory balance is significantly below current cost, which is common for LIFO, an assumption that often serves to reduce taxable income in order to decrease tax payments. Because of the LIFO conformity rule, use of that assumption for tax purposes requires that it also be adopted for financial reporting purposes. It is normally not used by foreign companies.

LIFO Liquidation

Question: In discussions of financial reporting, LIFO is also criticized because of the possibility of an event known as a LIFO liquidationA decrease in the quantity of inventory on hand when LIFO is applied so that costs incurred in a previous period are mismatched with revenues of the current period; if inflation has occurred, it can cause a significant increase in reported net income.. What is a LIFO liquidation and why does it create a theoretical problem for accountants?

Answer: As demonstrated above, costs from much earlier years often remain in the inventory T-account over a long period of time if LIFO is applied. With that cost flow assumption, a convenience store that opens in 1972 and ends each year with a full tank of 10,000 gallons of gasoline reports ending inventory at 1972 costs for years or even decades. Every balance sheet will show inventory as $10,000 (10,000 gallons in ending inventory at $1.00 per gallon).

However, if the quantity of inventory is ever allowed to decrease (accidentally or on purpose), some or all of those 1972 costs move to cost of goods sold. For example, if the convenience store ends 2012 with less than 10,000 gallons of gasoline, the reduction means that costs sitting in the inventory T-account since 1972 are recognized as an expense in the current year. Costs from 40 years earlier are matched with revenue in 2012. That is a LIFO liquidation and it can artificially inflate reported earnings if those earlier costs are especially low.

To illustrate, assume that this convenience store starts 2012 with 10,000 gallons of gasoline. LIFO has been applied over the years so that this inventory is reported at the 1972 cost of $1.00 per gallon. In 2012, gasoline costs the store $3.35 per gallon to buy and is then sold to the public for $3.50 per gallon creating a gross profit of $0.15 per gallon. That is the amount of income the store is making this year.

At the beginning of 2012, the convenience store sells its entire stock of 10,000 gallons of gasoline at the market price of $3.50 and then ceases to carry this product (perhaps the owners want to focus on groceries or automobile parts). Without any replacement of the inventory, the cost of the gasoline bought in 1972 for $1.00 per gallon is shifted from inventory to cost of goods sold in 2012. Instead of recognizing the normal profit margin of $0.15 per gallon or $1,500 for the 10,000 gallons, the store reports gross profit of $2.50 per gallon ($3.50 sales price minus $1.00 cost of goods sold) or $25,000 in total. The reported profit ($25,000) does not reflect the reality of current market conditions. This LIFO liquidation allows the store to look overly profitable.

In a LIFO liquidation, costs from an earlier period are matched with revenues of the present year. Revenue is measured in 2012 dollars but cost of goods sold is stated in 1972 prices. Although the reported figures are technically correct, the implication that this store earned a gross profit of $2.50 per gallon is misleading.

To warn decision makers of the impact that a LIFO liquidation has on reported net income, disclosure in the notes to the financial statements is needed whenever costs are mismatched in this manner. According to a note in the 2010 financial statements for Alcoa Inc. (all numbers in millions), “During the three-year period ended December 31, 2010, reductions in LIFO inventory quantities caused partial liquidations of the lower cost LIFO inventory base. These liquidations resulted in the recognition of income of $27 ($17 after-tax) in 2010, $175 ($114 after-tax) in 2009, and $38 ($25 after-tax) in 2008.”

Test Yourself

Question:

Margaret Besseler is studying the financial statements produced by Associated Chemicals of Rochester. Besseler notices that the footnotes indicate that a LIFO liquidation took place during the most recent year. Which of the following is least likely to be true?

Inventory quantities decreased during the year.
Reported net income was inflated by the LIFO liquidation.
The company converted from the use of LIFO to that of FIFO (or some other cost flow assumption).
Cost of goods sold was below the current cost of the inventory sold.

Answer:

The correct answer is choice c: The company converted from the use of LIFO to that of FIFO (or some other cost flow assumption).

Explanation:

A LIFO liquidation is a decrease in the quantity of inventory held by a company that applies LIFO so that a cost (often a much cheaper cost) from an earlier time period is moved from inventory to cost of goods sold. That artificially reduces this expense and, hence, increases both reported gross profit and net income. A LIFO liquidation is viewed unfavorably by accountants because an old, out-of-date (often much cheaper) cost is matched with current revenues.

Talking with an Independent Auditor about International Financial Reporting Standards (Continued)

Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.

Question: Companies in the United States are allowed to choose FIFO, LIFO, or averaging as an inventory cost flow assumption. Over the years, many U.S. companies have adopted LIFO, in part because of the possibility of reducing income taxes during a period of inflation. However, IFRS rules do not recognize LIFO as appropriate. Why does such strong resistance to LIFO exist outside the United States? If the United States adopts IFRS will all of these companies that now use LIFO have to switch their accounting systems to FIFO or averaging? How much trouble will that be?

Rob Vallejo: The International Accounting Standards Board revised International Accounting Standard No. 2, Inventories (IAS 2), in 2003. The issue of accounting for inventories using a LIFO costing method was debated and I would encourage anyone seeking additional information to read their basis for conclusion which accompanies IAS 2. The IASB did not believe that the LIFO costing method was a reliable representation of actual inventory flows. In other words, in most industries, older inventory is sold to customers before newer inventory. The standard specifically precludes the use of LIFO, but allows for the use of the FIFO or weighted average costing methods as the board members view these as better representations of actual inventory flows.

Therefore, when U.S. companies have to adopt IFRS, the inventory balances and the related impact on shareholders’ equity will be restated as if FIFO or average costing had been used for all periods presented. Most companies keep their books on a FIFO or weighted average cost basis and then apply a LIFO adjustment, so the switch to an alternative method should not be a big issue in a mechanical sense. However, the reason most companies apply the LIFO costing method relates to U.S. tax law. Companies that want to apply LIFO for income tax purposes are required to also present their financial information under the LIFO method. The big question still being debated is whether or not U.S. tax law will change to accommodate the move to IFRS. This is very important to U.S. companies, as generally, applying LIFO has had a cumulative impact of deferring the payment of income taxes. If companies must change to FIFO or weighted average costing methods for tax purposes, that could mean substantial cash payments to the IRS. This continues to be a very hot topic for accountants and U.S. government officials, as the cash tax implications are significant for many companies.

Key Takeaway

LIFO is used by many companies in the United States because of the LIFO conformity rule. However, troubling theoretical problems do exist. These concerns are so serious that LIFO is prohibited in many places in the world because of the rules established by IFRS. The most recent costs are reclassified to cost of goods sold so earlier costs remain in the inventory account. Consequently, this asset can continue to show inventory costs from years or even decades earlier—a number that would be of little use to any decision maker. In addition, if these earlier costs are ever transferred to cost of goods sold because of shrinkage in the quantity of inventory, a LIFO liquidation is said to occur. Although revenues are from the current year, the related cost of goods sold reflects very old cost numbers. Reported net income is artificially inflated. Thus, information about LIFO liquidations appears in the notes to the financial statements so readers can weigh the impact.