NAM
LIFO Inventory Training
May 12, 2009
Jim Martin
Managing Director - Washington,
DC
Circular 230 Notice
This document was not intended or written
to be used, and it cannot be used, for the
purpose of avoiding U.S. federal, state, or
local tax penalties.
General Inventory Principles
Why Inventories Are Important
•  Inventory is generally one of the largest items on
the balance sheet of a manufacturer or reseller
•  Ending inventory reduces cost of goods sold
-  Costs allocated to ending inventory are
deferred until the inventory is sold
-  A decrease in ending inventory value increases
COGS and reduces taxable income
General Inventory Principles (continued)
Why Inventories Are Important Cost Flow: LIFO Method
Advantage of LIFO
•  Ending inventory treated first as beginning
inventory then as inventory acquired during the
year
•  Matches current revenue with current costs,
effectively expensing inflation
Cost Flow: LIFO Method (continued)
Requirements incident to use of LIFO
•  Conformity requirement
-  Reduces financial statement earnings
-  Could affect which year LIFO can be adopted
-  Exceptions for certain foreign-owned
corporations
•  Cost requirement
Cost Flow: LIFO Method (continued)
Adoption of LIFO
•  Form 970
•  Scope of election
•  Adoption of submethods, including
•  Item definition
-  Pooling method
-  Indexing method
-  Current-year cost method
•  Timing and late elections
Cost Flow: LIFO Method (continued)
Specific Goods Method
The Specific Goods Method (sometimes referred to
as the Unit Method) uses quantities as a basis for
calculating LIFO.
Example
We begin business as a marble wholesaler in 1998
and purchase 10,000 marbles @ $.25 each. For
simplification, we will assume that there is only
one price per year.
Cost Flow: LIFO Method (continued)
In 1998, we purchase 10,000 marbles @ $.25
each and sell 9,000. At the end of the year we
have 1000 marbles.
Cost Flow: LIFO Method (continued)
In 1999, we purchase 12,000 marbles @ $.30
each and sell 11,500. At the end of the year we
have 1500 marbles.
Cost Flow: LIFO Method (continued)
In 2000, we purchase 1,000,000 @ $.35 each
and sell 990,000. At the end of the year we have
11,500 marbles.
Cost Flow: LIFO Method (continued)
In 2001, we purchase 10,000 @ $.40 each and
sell 15,000. At the end of the year we have
6,500 marbles.
Cost Flow: LIFO Method (continued)
Dollar Value Method
Under the dollar-value LIFO method, changes in
inventory are measured in terms of equivalent
base-year dollars rather than changes in
quantities. Cost Flow: LIFO Method (continued)
Cumulative Index Methods
Cumulative index methods compute a cumulative
inflation index, which is used to deflate current-year
cost to base-year cost and (generally) to inflate any
resulting increment
•  Double-extension – Extend 100% of items at current
cost and base cost
•  Index (Sampling) – Extend sample of items at current
cost and base cost
•  Link-chain – Extend 100% or sample of items at current
cost and prior-year cost; link to prior-year cumulative
inflation index
•  IPIC – Use published (CPI or PPI) inflation indexes
Cost Flow: LIFO Method (continued)
Inflation Indexes
If we determine through our methods that $1 in
2005 is worth $1.03 in 2008. We compute the
inflation on that dollar as follows: $1.03 / $1 =
1.03
Cost Flow: LIFO Method (continued)
Example – Index Calculation
Cost Flow: LIFO Method (continued)
Cumulative Inflation Indexes Under the “link chain” method, inflation is
computed one year at a time and then the annual
inflation percentages are combined into a
cumulative inflation index.
The values of a certain machine are as follows:
$1000 in 2000
$1025 in 2001
$1040 in 2002
$1090 in 2003
Cost Flow: LIFO Method (continued)
The simplest way to compute the inflation from
2000 to 2003 is:
$1090 / $1000 = 1.09
Cost Flow: LIFO Method (continued)
This also works with the “link-chain” method:
First compute the inflation for each of the individual
years:
$1025 / $1000 = 1.025000
$1040 / $1025 = 1.014634
$1090 / $1040 = 1.048077
Cost Flow: LIFO Method (continued)
Then multiply each of the annual inflation
indexes together:
1.025000 * 1.014634 * 1.048077 =1.09000
Cost Flow: LIFO Method (continued)
Dollar Value, Link-Chain Example
A marble wholesaler started business in 1997.
The ending inventory at FIFO cost was $1,000,000.
For the year ending 12/31/98, the company is
ready to elect LIFO (if it is beneficial). Ending
inventory @ FIFO cost for 12/31/98 is $1,500,000.
Assume annual inflation to be 3%.
Cost Flow: LIFO Method (continued)
1997 Inv @ FIFO $1,000,000
1998 Inv @ FIFO $1,500,000
Annual Inflation 3%
Set up our layer history with our beginning
inventory:
Cost Flow: LIFO Method (continued)
Definitions of Layer History Labels
Date - The year-end for which the layer is attributed.
Base - The layer stated in terms of the base year cost. In
this case the base year is 1997.
Inflator - An index measuring the inflation from the base
year to the year of the layer.
LIFO - The layer stated in terms of the year of the layer.
Cumulative Index - An index measuring the inflation from
the base year to the current year.
LIFO Reserve – Usually, the difference between CurrentYear Cost (e.g., FIFO) and LIFO Value
Cost Flow: LIFO Method (continued)
1998 Inv @ FIFO $1,500,000
Annual Inflation 3%
First, restate the 12/31/98 FIFO cost in terms of
the base year (1997).
Cost Flow: LIFO Method (continued)
Next, compare ending inventory at base to
beginning inventory at base.
Cost Flow: LIFO Method (continued)
When there is an increment, we must add the
increment @ base as the next layer @ base, and,
for the LIFO column, state that layer in terms of the
year of the layer (multiply it by the cumulative
index from 1997 to 1998).
Cost Flow: LIFO Method (continued)
For the year ending 12/31/99, ending inventory @ FIFO
cost is $1,800,000. Assume annual inflation to be 2%.
First, multiply the prior year cumulative index by the
current annual inflation to determine the current year
cumulative index.
Cost Flow: LIFO Method (continued)
Next, divide the ending inventory at FIFO cost by
the current year cumulative index to determine
ending inventory @ base.
Cost Flow: LIFO Method (continued)
Next, compare ending inventory at base to
beginning inventory at base.
Cost Flow: LIFO Method (continued)
Then add the increment @ base as the next layer
@ base, and, for the LIFO column, state that layer
in terms of the year of the layer (multiply it by the
cumulative index from 1997 to 1999).
Cost Flow: LIFO Method (continued)
For the year ending 12/31/00, ending inventory @ FIFO
cost is $1,200,000. Assume annual inflation to be 1%.
First, multiply the prior year cumulative index by the
current annual inflation to determine the current year
cumulative index.
Cost Flow: LIFO Method (continued)
Next, divide the ending inventory at FIFO cost by
the current year cumulative index to determine
ending inventory @ base.
Cost Flow: LIFO Method (continued)
Next, compare ending inventory at base to
beginning inventory at base.
Cost Flow: LIFO Method (continued)
When there is a decrement, we need to decrease
our layers at base, newest layers first, by an amount
equal to the total decrement. For 2000, our
decrement will be as follows:
Cost Flow: LIFO Method (continued)
We can portray this by showing all increments
and decrements in our layer history.
Cost Flow: LIFO Method (continued)
While this helps us understand what happened in
2000, portraying the layers this way will cause
additional work in subsequent years. Therefore it is
better to net each of the values together and only
show the layers that remain.
Cost Flow: LIFO Sub-Methods
Item Definition: Importance
•  Inflation measured for items in the pool
•  Change in mix of items will affect the index
•  New items added at current year cost, unless
cost can be reconstructed
Cost Flow: LIFO Sub-Methods (continued)
Item Definition: Scope
•  Character, quality, and price
•  Manufacturers – part or product number
•  Resellers - SKU
Cost Flow: LIFO Method (continued)
Pooling: Relevance
•  Increments and decrements are determined for a
pool
•  Increases of items in a pool are offset by
decreases of other items in the pool, avoiding
decrements into old (low cost) layers
Cost Flow: LIFO Method (continued)
Pooling: Manufacturers
•  Natural Business Unit (NBU) pool
-  All inventory for the NBU, but not resale goods
•  Raw material content pools
•  Multiple pools
-  By raw material type
-  Finished goods and WIP by type or class
•  IPIC pools
Cost Flow: LIFO Method (continued)
Pooling: Resellers
•  By major line, type, or class
•  IPIC pools
Cost Flow: LIFO Method (continued)
Ending Inventory @ Current-Year Cost
The cost of inventory at year-end stated in terms
of current-year dollars.
•  Specific ID
•  Earliest Acquisitions
•  Most Recent Purchases (FIFO)
•  Average Cost of Purchases During the Year
•  Other (e.g., Replacement Cost; RIM Cost)
QUESTIONS?
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