For companies considering adopting the use of the LIFO method, there are many options available to chose from in order to implement LIFO & perform the calculation. One of the most fundamental options is the LIFO index computation method chosen. The two options available are as follows:
- Dollar value method – A shortcut cost flow method which measures inventory layers in terms of dollars rather than physical units. Inventory items are grouped by pools and are priced in terms of each pool’s aggregate base year cost. The result is compared to each pool’s aggregate base year cost at of the end of the prior year to determine whether the inventory levels have increased or decreased.
- Specific Goods Method (Unit LIFO) – An approach to applying LIFO in which changes in the quantity of individual types of inventory are the basis for determining whether the inventory levels have increased or whether a portion of the existing inventory has been liquidated.
Although unit LIFO is the method used to teach the concept of LIFO in accounting textbooks & LIFO “how-to” guides, the dollar value LIFO method is the most predominantly used index computation method in practice. This blog outlines the reasons why dollar-value LIFO is used in practice by the vast majority of companies on LIFO.
- Comparing the Administrative Burdens of LIFO
- Unit LIFO
- Under unit LIFO, a company’s accounting information system would have to be overhauled to track all item costs at LIFO. In other words, each item is required to be “LIFO-ized” or tracked at the item level on a LIFO basis from the year of LIFO adoption, and those costs must continue to be tracked at LIFO in perpetuity.
- This often can pose a huge administrative burden because all prior item costs must be maintained for all items until the item is no longer in stock. For example, a company on LIFO for 25 years would have to maintain 25 years worth of item costs for all items that have been present in inventory since the LIFO election or base year.
- For management, forecasting & planning purposes, companies use cost flow methods such as FIFO, average cost or standard cost because those more accurately represent current item costs.
- For companies using unit LIFO, item costs would need to be tracked under multiple cost flow methods in order to calculate the LIFO inventory balance & perform basic management accounting tasks such as forecasting sales, purchases & the like.
- Maintaining multiple item cost flow methods within an accounting system creates a large administrative burden and often increases the costs of maintaining item costs
- Dollar value LIFO (DVL)
- Accounting information system responsible for tracking item costs & LIFO calculation are decoupled from one another. In other words, individual items are never LIFO-ized or tracked at the item level on a LIFO basis
- Under DVL, no accounting information system (AIS) overhaul is required, and item costs continue to be tracked under the same cost flow method used prior to electing LIFO. In other words, the AIS tracks costs as if you weren’t on LIFO.
- An annual side calculation is made outside of the AIS at year end to compute the current year inflation & the LIFO inventory/reserve balance
- A LIFO reserve contra inventory account is simply added to the general ledger inventory subledger to adjust the ending inventory balance from cost to LIFO (where cost represents the cost flow method used in the AIS; FIFO & average cost are the most predominantly-used AIS cost flow methods)
- Under DVL, the best of both worlds can be accomplished because item costs continue to be tracked under the same cost flow method historically used, while the LIFO reserve continues to accumulate & create tax savings
- Unit LIFO
- Comparing the Tax Savings From LIFO
- Unit LIFO
- Under unit LIFO, a portion of the LIFO reserve is recaptured on items that are no longer in inventory at the current year end, but were in the prior year end. This includes discontinued & replacement items.
- The recapture that occurs on new items under unit LIFO is similar to the recapture that occurs with a lower of cost or market reserve (LCM), where the LCM reserve is reduced when any good with a reserve associated with it is sold.
- Dollar-value LIFO
- Under DVL, the change in the LIFO reserve is calculated in an aggregated manner, not on an item by item basis as is the case under unit LIFO. Under the dollar-value approach, the change in the LIFO reserve occurs in a two-step fashion. Those two steps occur in the following order:
- Front-end:
- Current year/cumulative inflation index calculation
- Current and prior/base year unit costs extended against current quantities on an item by item basis to calculate a current year index
- Current year index multiplied times prior year cumulative index to calculate current year cumulative index
- Current year/cumulative inflation index calculation
- Back-end: Current year LIFO calculation
- Current year inventory at base year costs calculated
- Increase (decrease) at base year costs calculated (layers at base year cost or decrements if there are decreases)
- Increase (decrease) at LIFO cost calculated (layers at LIFO cost or decrements if there are decreases)
- Current Year LIFO inventory balance calculated (sum of the layers at LIFO cost)
- Current Year LIFO reserve calculated (current year inventory at cost i.e. FIFO/average cost – LIFO inventory balance)
- Current Year LIFO expense (income) calculated (current – prior year LIFO reserve)
- Front-end:
- Under dollar-value LIFO approach, the LIFO reserve remains intact even when preexisting items are no longer in stock at the end of the year as long as the value of the replacement goods is greater than or equal to the value of the goods no longer in stock.
- Under DVL, LIFO reserve is only reduced by the following:
- Deflation
- Inflation paired with a current year inventory balance at cost that is less than the product of the prior year inventory balance at cost & the current year inflation rate (AKA layer-erosion LIFO income)
- LIFO reserve often increases even when there was a decrease in the current vs. prior year inventory balance at cost because the inflation effect LIFO expense component of the LIFO reserve calculation will be greater than the layer erosion effect LIFO income. See LIFOPro’s blog: How your lifo reserve can increase even when CY vs. PY balances decrease
- Under DVL, the change in the LIFO reserve is calculated in an aggregated manner, not on an item by item basis as is the case under unit LIFO. Under the dollar-value approach, the change in the LIFO reserve occurs in a two-step fashion. Those two steps occur in the following order:
- Unit LIFO
Summary
- From an administrative burden perspective, dollar value LIFO is the preferred LIFO method because it will always minimize the amount of administrative burden to implement LIFO compared to the specific goods or unit LIFO alternative.
- Companies should never use unit LIFO even if their accounting system supports tracking costs under unit LIFO.
- Although no accounting system exists to simultaneously track item costs under cost flow methods such as FIFO while also performing the annual dollar value LIFO calculation, the LIFOPro software automates dollar-value LIFO calculations for all situations, and our turnkey outsourcing solutions allows LIFOPro to manage all the work required to complete dollar-value LIFO calculations.
- From a tax savings perspective, dollar value LIFO is the preferred LIFO method because it will always create a higher LIFO reserve compared to the specific goods LIFO alternative.
- Over a long period of time, the dollar-value LIFO reserve can become several times larger than it would have been if unit LIFO were to have been used
- The longer a company is on LIFO, the larger the disparity between the dollar-value vs. specific goods LIFO reserve will become