Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories

1-2. Accounting Research Bulletin (ARB) No. 43, Chapter 4, paragraph 6 recognizes LIFO as an acceptable inventory method; but neither that pronouncement nor any other authoritative pronouncement provides implementation guidelines. In contrast, the Internal Revenue Code and regulations provide some specific LIFO implementation rules and include a basic requirement that companies using LIFO for income tax purposes must also use LIFO for financial reporting purposes. This is known as the LIFO conformity requirement and is discussed more fully in section seven of this paper. Because of the paucity of authoritative accounting literature and the relative specificity of the tax rules related to LIFO, the general approach to LIFO has been: "whatever is good for tax is good for financial reporting."

1-3. The task force believes portions of the Internal Revenue Code and regulations concerning LIFO have considerable merit and may be used for financial reporting purposes; other portions, however, may be inappropriate in certain circumstances for such purposes. In addition, maintaining two sets of LIFO records, one for financial reporting and one for tax reporting, would likely be burdensome and costly to most businesses. The task force therefore believes cost-benefit considerations should be weighed in applying financial accounting and reporting principles that do not embrace, to the extent practicable, income tax accounting requirements.

1-4. Evidence of the need for more specific authoritative accounting guidance includes the general lack of authoritative accounting guidance, the wide range of variations possible among acceptable ways to calculate LIFO, the Internal Revenue Service's (IRS) softening of its interpretation of the LIFO conformity requirement (discussed more fully in section seven of this paper) and an IRS regulation that simplifies LIFO application for income tax purposes (the focus of a separate issues paper prepared by the task force and sent to the Financial Accounting Standards Board on October 14, 1982). Further, on July 2, 1981, the Securities and Exchange Commission (SEC) issued Accounting Series Release (ASR) No. 293, "The Last-In, First-Out Method of Accounting for Inventories," which provides examples of what the SEC considers inappropriate applications of LIFO and exhorts registrants and their accountants to ensure that the application of LIFO achieves the stated conceptual objective of properly matching most recently incurred costs with current revenues. ASR No. 293 was subsequently incorporated into Section 205 of Financial Reporting Release (FRR) No. 1, "Codification of Financial Reporting Policies."

Temporary Differences Related to LIFO Inventory and Tax-to-Tax Differences — EITF Topic No. D-31

1-7. The objective of LIFO is to match most recently incurred costs with current revenues by charging cost of goods sold with the costs of goods most recently acquired or produced. So, in periods of rising prices, a company's reported cost of goods sold under LIFO is generally greater than it would have been had the first-in, first-out (FIFO) method of inventory been used. Consequently, using LIFO in periods of rising prices generally produces a reported net income smaller than that had FIFO been used. The following simplified illustration contrasts the effects of LIFO and FIFO.

1-8. LIFO is widely used and its use is growing. The 1983 edition of Accounting Trends & Techniques shows that in 1982, 407 of the 600 companies surveyed used LIFO for at least part of their inventories, compared with only 150 such companies a decade earlier. The principal business reasons for this growth apparently have been to maximize after tax cash flow from operations and to eliminate from reported income so called illusory inventory profits in periods of rising prices. Yet, some have challenged LIFO as conceptually unsound because they believe LIFO, among other things, violates the acquisition (historical) cost principle of accounting. Others have challenged LIFO because they believe LIFO enables a company to manipulate its income by entering into transactions, particularly near year end, whose primary purpose is to increase or decrease inventory levels. Despite those concerns, this paper does not challenge LIFO as an acceptable inventory method, because its acceptability is well established in the authoritative accounting literature (ARB No. 43) and in practice.

1-12. Specific Goods Approach. Under the specific goods approach, changes in the quantity of individual types of inventory are the bases for determining whether inventory levels have increased or whether a portion of the existing inventory has been liquidated.

1-13. Dollar Value Approach. Under the dollar value approach, inventory items are grouped by pools and are priced in terms of each pool's aggregate base year cost. The result is compared with each pool's aggregate base year cost as of the end of the prior year to determine whether the inventory level of each LIFO pool has increased or whether a portion of the inventory has been liquidated. Various computational techniques are used with the dollar value approach, including:

1. Double extension, in which the current and base year costs of each item in inventory are multiplied, or extended, by the units on hand at the current year reporting date.
2. Internal index, in which the base year cost of ending inventory is determined by applying an index (based on a sample of current year costs to base year costs of items in inventory) to the dollar value of the ending inventory at current year cost.
3. Link chain, in which the base cost of ending inventory is determined by applying a cumulative index to the dollar value of the ending inventory. The cumulative index is the relationship of the current year prices to those of the prior year (based on either double extension or internal index) multiplied by the prior year's cumulative index, causing each year's index to be characterized as a link in a chain of indexes back to the base year.
4. External index, in which the dollar value of ending inventory at current year prices is restated to approximate the base year prices using an index determined by an outside source, such as the Bureau of Labor Statistics Index.

1-14. Appendix I to this paper illustrates the application of various computational techniques.

2-2. Many disadvantages associated with the specific goods approach are avoided by using the dollar value approach. Under that approach, inventory quantities are measured in terms of fixed dollar equivalents (base year costs) rather than quantities and prices of specific goods. Similar items of inventory are aggregated to form inventory pools, and increases or decreases in each pool are identified and measured in terms of the total base year cost of the inventory in the pool rather than the physical base year quantities of individual items. To determine whether the inventory has changed, a company states dollars of ending inventory in terms of a common base year (the year LIFO is adopted). Changes in the base year dollars are measured in one of several ways. Changes in quantities and product mix within a pool may occur without affecting the total dollar value of the pool.

2-3. Issue. May both the specific goods and dollar value approaches to LIFO be used for financial reporting purposes?

2-4. Discussion. Both the specific goods and dollar value approaches are considered compatible with the LIFO objective and both are widely used in practice. The choice of one approach over the other largely depends on practical considerations. The dollar value approach is generally the more practical approach in light of the pace of technical changes and is used more often in practice than the specific goods approach. For example, companies with many different products or frequent technological changes in their product lines generally find it onerous and impractical to apply the specific goods approach, and, therefore, use the dollar value approach. In contrast, companies with relatively small and stable product lines can often apply the specific goods approach more easily.

2-5. Advisory Conclusion. The task force believes (9 yes, 0 no) either the specific goods or dollar value approach to LIFO consistently applied is generally compatible with the LIFO objective and, accordingly, either may be used for financial reporting purposes.

2-7. Arguments. Some believe disclosure of the LIFO approach used is useful and meaningful, because an entity's reported income depends on, among other things, the way LIFO is calculated. They further believe this disclosure enhances comparability. Notwithstanding those arguments, some believe this disclosure is now required by APB Opinion 22, which requires disclosure of all significant accounting policies, that is, specific accounting principles and the methods of applying them.

2-8. Other believe that, unaccompanied by other information, disclosure of the LIFO approach used does not enable users to quantify the effects of the approach used. Indeed, some believe the benefits of providing the extensive other information necessary to allow users to quantify the effects of the LIFO approach used are rarely worth the costs involved. Further, some believe the authoritative accounting literature does not prescribe this disclosure for non-LIFO inventories (for example, the manner in which factory overhead is allocated), because such information generally has not been viewed as meaningful. Notwithstanding those arguments, some believe the way LIFO is calculated is not a significant accounting policy contemplated by APB Opinion 22, and such information is normally too complex for the average financial statement user to comprehend.

2-9. Advisory Conclusion. The task force believes (7 yes, 2 no) the LIFO approach used need not be disclosed.

2-11. Issue. May all those pricing approaches (the order of acquisition price, the most recent acquisition price, and the average acquisition price) be used for financial reporting purposes?

2-12. Arguments. Some believe all three pricing approaches may be used for financial reporting purposes because each approach consistently applied produces income results compatible with the LIFO objective. Some also oppose restriction to one approach for practical considerations. They believe such restriction could produce benefits rarely worth the costs of the additional recordkeeping necessary for a company to change from the approach it now uses. Others believe seasonal businesses need to be able to choose the approach that best matches most recently incurred costs and current revenues and that use of the earliest acquisition price sometimes does not achieve that goal. Also, pricing increments is only one element of the LIFO calculation and the practical considerations of the application require some flexibility in calculation techniques and the issue is significant only if price changes are significant. Further, all the approaches are used in practice today with no perceived problems because of the diversity.

2-13. Others believe only one approach should be used for financial reporting purposes for comparability. They believe comparability justifies the additional costs of recordkeeping. Some contend that all those approaches can and often do produce significantly different amounts of reported income. Also, they point out that most businesses are not seasonal.

2-14. Among those who believe only one approach should be used for financial reporting purposes, views differ on which of the three approaches should be used. Some believe only the order of acquisition price approach should be used for financial reporting purposes because they believe it is conceptually more compatible with the LIFO objective than the other approaches because it causes latest acquisition costs to be charged to cost of sales. Others believe only the most recent acquisition price approach should be used for financial reporting purposes, because it is the easiest to determine. Still others believe average purchase price represents a viable compromise.

2-15. Advisory Conclusion. The task force believes (9 yes, 0 no) the order of acquisition approach generally is most compatible with the LIFO objective but as a practical matter any of the three pricing approaches consistently applied may be used for financial reporting purposes.

330-10-30 (Q&A 14) Accounting for LIFO Increments and Variances Under the Order of Acquisition Approach

330-10-30 (Q&A 15) Accounting for LIFO Increments and Variances Under the Order of Acquisition Approach)

2-17. The following illustrates the alternative approaches:

2-18. Arguments. Some believe the purchase price should be based on the acquisition or production cost of the quantity of the increment, because the acquisition or production cost of the increment is the cost incurred by the enterprise and is the most relevant cost for this purpose. They believe pricing the increment at the acquisition or production cost equal to the increment is also most compatible with the "flow of costs" assumption that serves as the underlying conceptual basis for LIFO inventory accounting. Under the LIFO concept, the cost of acquiring quantities in excess of the amount of the increment is irrelevant. Moreover, it imposes an additional and unnecessary cost if companies are required to price the higher quantity of the full ending inventory. Also, this calculation creates a timing problem because it can only be completed after the full quantity of the ending inventory is known at year end.

2-19. The task force understands that in certain cases, the IRS has taken the position that for tax purposes purchase price should be based on the acquisition or production cost of a quantity equal to the ending inventory because that approach provides a broader pricing base and tends to lessen the effect of abnormal costs that might be associated with using a smaller quantity for this purpose, and that the IRS has required some companies to use this method for tax purposes.

2-20. Advisory Conclusion. The task force believes (8 yes, 1 no) the price used to determine the inventory increment should be based on the acquisition or production cost of the quantity or dollars at least approximating the increment.

2-22. Arguments. The arguments for and against disclosing the approach used to price current increments are essentially the same as the arguments for and against disclosing the LIFO approach used in paragraphs 2-7 and 2-8 of this paper.

2-23. Advisory Conclusion. The task force believes (7 yes, 2 no) the approach used to price current increments need not be disclosed.

330-10-30 (Q&A 16) Financial Reporting Effect of LIFO Reserve Recapture for Tax Purposes

2-25. Issue. Should either the LIFO reserve or replacement cost be disclosed?

2-26. Arguments. Some believe the LIFO reserve or replacement cost should be disclosed because they believe many users of financial statements find that information useful and meaningful, especially for analyzing the effects of price changes; for better understanding the financial position of the company; and for comparing such effects with those of other companies. Some also believe consistent use of LIFO over an extended period produces a balance sheet carrying amount for inventory substantially below current reproduction or replacement cost. Some note that the SEC already requires companies whose securities trade publicly to disclose this information [Regulation S-X, Rule 5.02-6(c)] and that many nonpublic companies already disclose this information. Accordingly, they believe that information often is readily available and its disclosure requires little extra effort by the reporting entity. Supporters of disclosure believe any of the following disclosures on the face of the balance sheet or in the notes is acceptable:

• Disclosure of LIFO reserve.
• Disclosure of non-LIFO amount.
• Disclosure of non-LIFO amount with LIFO reserve reduction shown arriving at net inventory cost.

2-27. Others believe the LIFO reserve or replacement cost need not be disclosed because they believe the information is neither useful nor meaningful, and, in fact, could detract from LIFO as a proper measurement method. Others point out that non-LIFO companies currently are not required to disclose replacement cost for their inventories and that no company is required to disclose the current cost of other assets in its primary (historical cost) financial statements. Notwithstanding those arguments, some believe disclosures should be made only if they are useful, meaningful, and appropriate for all companies, not simply because they are easy to present or required by certain regulatory agencies. For example, enterprises using straight line depreciation in their primary statements are not required to disclose what the book value of property and equipment would have been had accelerated depreciation been used.

2-28. Advisory Conclusion. The task force believes (9 yes, 0 no) either the LIFO reserve or replacement cost and its basis for determination should be disclosed.

Disclosure of LIFO Reserve — AICPA Technical Practice Aids (TIS Section 2140.14)

3-2. Intercompany transactions can cause swings in LIFO inventories, particularly if a receiving subsidiary is not on LIFO. Transfers to non-LIFO subsidiaries could be used to liquidate LIFO inventories on an individual reporting unit basis though maintaining in the aggregate the inventory levels. Those examples raise the question of the advisability of an enterprise adopting LIFO piecemeal. The task force plans to consider separately the accounting implications of transfers of inventories between LIFO and non-LIFO pools or components of a consolidated group.

Elimination of Profits Resulting From Intercompany Transfers of LIFO Inventories — AICPA Practice Bulletin No. 2

3-3. A search of the 1979/1980 NAARS file, the most recent completed file at the time of the search, revealed that a substantial number of companies, about 600, had adopted LIFO for some but not all inventories.

3-4. Issue. May a company that changes to LIFO for financial reporting purposes make the change for only part of its inventory?

3-5. Arguments. Some believe a company that changes to LIFO for financial reporting purposes may make the change for only part of its inventory, because they believe many businesses have valid reasons for not adopting LIFO for all their inventories, such as anticipating significant price changes to affect only one portion of the inventory, greatly fluctuating inventory levels, anticipated significant reductions in certain inventories, impracticality of total immediate adoption because of cost or manpower considerations, statutory financial reporting requirements for foreign subsidiaries, nonrecognition for tax purposes of LIFO in certain foreign countries or volatility of prices. Also, divisions of a business and components of its inventories may differ significantly, so some argue that different inventory methods may be appropriate in different circumstances. Some also believe a company that changes to LIFO for financial reporting purposes may make the change for only part of its inventory, because they believe some matching of most currently incurred costs and current revenues is better than no matching at all. Some point out that the authoritative accounting literature generally does not prescribe that all assets in a given category be accounted for the same way. For example, the literature does not prescribe that all plant, property, and equipment be depreciated the same way. They also believe that because companies may adopt FIFO for parts of their inventory and average cost for other parts without justification, no justification is necessary for LIFO. Further, some believe companies involved in a business combination are not required to conform their inventory methods after the combination.

3-6. Others believe a company changing to LIFO for financial reporting purposes may not make the change for only part of its inventory, because they believe a company's main reason for only partially adopting LIFO is to avoid a large income statement effect in one year thus enabling a business to manipulate income by arbitrarily deciding when and to what extent to adopt LIFO. As a result, they believe that sacrifices consistency. Further, they contend that two or more inventory methods cannot all be appropriate for the same company. Accordingly, they believe all assets in a major category should be accounted for the same way even if the authoritative accounting literature has no requirement.

3-7. Advisory Conclusion. The task force believes (7 yes, 2 no) there should be a presumption that if a company changes to LIFO, it should do so for all its inventories and that presumption can be overcome only if it has a valid business reason for not fully adopting LIFO, such as a valid business reason discussed in paragraph 3-5.

3-9. Issue. Should planned gradual adoption of LIFO be permitted for financial reporting purposes?

3-10. Arguments. Because this issue is so related to the issue on whether a company may change to LIFO for only part of its inventory, the arguments are essentially the same for and against this issue.

3-11. Advisory Conclusion. The task force believes (9 yes, 0 no) a company that has valid business reasons for a planned gradual adoption of LIFO may follow that course of action. However, a planned gradual adoption of LIFO solely to lessen the income statement effect in any one year is not, in the task force's view, a valid business reason.

3-13. Arguments. Some believe that by its silence, APB Opinion 20 requires that only the change be justified as preferable.

3-14. Others believe APB Opinion 20 implies that a change in an accounting principle should apply to all transactions or items in a given class. They believe that presumption is overcome only if preferability is determined for both the changed and unchanged portions.

3-15. Advisory Conclusion. AcSEC believes (7 yes, 6 no) a company partially or gradually adopting LIFO should justify as preferable in the year of change both the change to LIFO and the continued use of the non-LIFO method for the remaining inventories. The task force, in contrast, believes (8 yes, 1 no) such a company need only justify as preferable in the year of change the change to LIFO.

3-17. Arguments. Some believe the extent to which LIFO is used for companies that have not fully adopted LIFO should be disclosed because they believe this information is necessary to compare the financial statements with those of other companies. They point out that the International Accounting Standards Committee supports this disclosure (IASC Statement 3, paragraph 39). Because various alternatives exist to measure the extent of LIFO in use, including the portion of total inventory on LIFO and the LIFO portion of reported cost of sales, some believe the most beneficial way to assess the effects of partial adoption of LIFO is to disclose the portion of cost of sales measured using the LIFO method. While accepting that view, they believe it is usually neither practical nor worth the cost to make this disclosure and that disclosure of the portion of ending inventory on LIFO to total ending inventory is a practical and cost effective surrogate of this disclosure.

3-18. Others believe the extent to which LIFO is used need not be disclosed by companies that have not fully adopted LIFO because they believe the authoritative accounting literature currently requires no disclosure of the extent of alternative accounting treatments used. For example, disclosure of the amount of equipment being depreciated under an accelerated, as opposed to straight line, method is not required. And, they believe such information is neither useful nor meaningful.

3-19. Other arguments for and against disclosing the extent to which LIFO is used by companies that have not fully adopted LIFO are essentially the same as the arguments for and against disclosing the LIFO approach used in paragraphs 2-7 and 2-8 of this paper.

3-20. Advisory Conclusion. The task force believes (9 yes, 0 no) the extent to which LIFO is used should be disclosed by companies that have not fully adopted LIFO. Since various alternatives exist to measure the extent to which LIFO is used in the financial statements, the task force believes (8 yes, 1 no) that, conceptually, the portion of cost of sales resulting from the application of LIFO compared to reported cost of sales is the most indicative measure of the extent to which a company uses LIFO.

3-21. However, because it is often impractical to determine that amount, the task force believes disclosure of the portion of ending inventory priced on LIFO also indicates the extent to which LIFO is used in the financial statements (9 yes, 0 no), and companies should disclose the dollar amount of balance sheet inventories priced at LIFO and under other methods. Disclosure of those amounts are most meaningful when interrelated with disclosure of the LIFO reserve.

4-2. Concern has been expressed that companies may be creating new pools for new inventory items substantially similar to items in existing pools, resulting in pricing the items in the new pool higher than if they were considered to be replacing items removed from a pre-existing pool. Also, concern has been expressed that companies may have the opportunity to manipulate profits by creating many pools containing fewer items, thus increasing the opportunities for profit from liquidations due to recognition of income from decreases in one pool with offsetting increases in another pool because of a transfer of inventory between the pools. Further, the greater the number of pools, the greater the opportunities for liquidations.

4-3. Issue. Should financial reporting guidance be provided regarding the composition and establishment of LIFO pools?

4-4. Arguments. Some believe that to narrow the wide variations in practice that exist in pooling (even within the same industries), financial reporting guidance should be provided to promote comparability. Further, they believe that because pooling is an important step in the process of pricing inventory under dollar value LIFO, guidance is necessary to decrease the likelihood that income would be affected as a result of temporary, casual, or arbitrary shifting of inventory items from one pool to another. In addition, guidance is necessary because some companies use or wish to change to a different pooling approach for financial reporting purposes than for income tax purposes. They believe that generally accepted accounting principles for pooling should not solely depend on income tax regulations. They believe the guidance for pooling should permit flexibility and management judgment but should prohibit pooling approaches that could artificially distort income or may not reflect the economic activity of the enterprise. Further, those who believe guidance is necessary believe that, in general, a pool should reflect an economic activity or segment of business of an enterprise rather than an arbitrary grouping of inventory items. They believe that this pooling guidance is generally more consistent with the LIFO concept because, for each economic activity or segment of business of the enterprise, cost of goods sold would reflect the cost of goods most recently acquired or produced for that activity or segment. Variations of individual items within the activity or segment from year to year will offset and only the overall increase or decrease in that activity or segment will be reflected in income.

4-5. Others believe no widespread abuse exists in these areas, and therefore financial reporting guidance is unnecessary. Further, the authoritative accounting literature provides no guidance on grouping inventories for non-LIFO pools. For example, manufacturing overhead may be allocated among groups of plants, all products within a plant, or separate product lines, cost centers, or machine centers. They believe adopting pools appropriately depends on the organization or management structure of an entity. Companies in the same industry may have differing management styles, manufacturing systems, cost structures or distribution systems. They believe those factors require flexibility and preclude definitive guidance. They believe the longstanding income tax regulations have provided effective financial accounting and reporting guidance.

4-6. Advisory Conclusion. The task force believes (9 yes, 0 no) the objective of LIFO inventory pooling is to group inventory items to match most recently incurred costs to current revenues, after considering the manner in which the company operates its business. The task force further believes it is not feasible to formulate detailed financial accounting guidance for selecting pools that could apply to all enterprises. However, it believes there should be valid business reasons for establishing LIFO pools and establishing separate pools with the principal objective of facilitating inventory liquidations is unacceptable.

4-7. Issue. Should the existence of a separate legal entity that has no economic substance be reason enough to justify separate LIFO pools?

4-8. Arguments. Some believe substantially similar items should not be included in different pools merely because of the legal structure of the enterprise. They believe that substance should govern over form and similar items that comprise a similar or identical product sold to unaffiliated customers should be included in the same pool because it represents the same economic activity of the enterprise. Further, they believe the concept of LIFO, to charge cost of goods sold with the cost of goods most recently acquired or produced, could be violated if one pool has an increment and another pool has a decrement, but in the aggregate there is an increment.

4-9. Others believe the legal structure of an enterprise is reason enough for establishing pools, and accordingly, substantially similar items may be included in different pools simply because it is a separate entity. They believe establishing pools appropriately depends on the legal form of the organization just as it appropriately depends on its economic substance.

4-10. Advisory Conclusion. The task force believes (9 yes, 0 no) there should be reasons other than the existence of a separate legal entity to justify establishing separate LIFO pools.

4-12. Arguments. The arguments for and against disclosing pooling arrangements are essentially the same as those for and against disclosing the LIFO approach used in paragraphs 2-7 and 2-8 of this paper.

4-13. Advisory Conclusion. The task force believes (8 yes, 1 no) pooling arrangements need not be disclosed.

4-15. In ASR No. 293, the SEC discusses enforcement actions related to new product designations in which items were designated new products, and recorded at current costs without reconstruction, because of "insignificant and sometimes arbitrary differences," such as slight differences in chemical composition; changes in manufacturing, production, and location; and differences in supply sources.

4-16. Problems associated with defining and accounting for new items are generally obviated when the link chain technique is used or base year cost is reconstructed. Paragraph 4-23 of this paper illustrates that.

4-17. Issue. Should new item be defined for financial reporting purposes?

4-18. Arguments. Some believe new item should be defined for financial reporting purposes because the decision whether an item is new could significantly affect both the calculation of the index and total base year costs unless reconstructed base year costs or the link chain technique is used. To illustrate: a manufacturer that produces a standard grade product begins producing a costlier higher grade product. If the higher grade product is not considered a new item, the index compares the current year's high grade (more costly) product to the prior or base year's standard grade (less costly) product.

4-19. Others believe judgment is always necessary in defining a new item, because the particular facts and circumstances vary. They also note that the broad, general IRS requirements have created no widespread abuses in practice. Therefore, they believe it is unnecessary for new item to be defined for financial reporting purposes. They further believe the accounting systems of companies vary in their abilities to distinguish between certain items that only differ slightly. For example, parts or components that differ in size or style but serve similar functions may be assigned different part numbers. Sorting through all such part numbers for similar item is impractical, if not impossible.

4-20. Still others believe that some type of financial reporting guidance should be provided so that some measure of consistency in the application of this aspect of the LIFO method of accounting can be obtained. Those holding this view accept the premise that judgment is necessary when assessing whether a new item is present, but they reject the notion that a new item should be defined to avoid significant variations in the LIFO cost calculations, notwithstanding the existence of such variations.

4-21. Advisory Conclusion. The task force believes (9 yes, 0 no) that new item need not be defined for financial reporting purposes because the task force supports the use of the reconstructed cost method and the link chain technique (see paragraph 4-27). However, the task force believes (8 yes, 1 no) the following guidance is appropriate:

4-23. The following illustrates the effects of applying the current cost and reconstructed base year cost approaches using the double extension and link chain techniques.

4-24. Thus, of $68,720 added current inventory costs in 19X3 ($57,750 new items plus $10,970 of price changes on existing items), the link chain and reconstructed cost techniques produce charges to cost of sales of about the same amount. Use of the most recently incurred costs of new items produces higher inventory amounts and smaller charges to cost of sales than the other techniques. The link chain or reconstructed cost technique usually produces a more conservative result.

4-25. Arguments. Some favor the current acquisition cost approach, because they believe that approach is more objective and is more compatible with the historical cost framework than the reconstructed cost approach.

4-26. Others favor the reconstructed cost approach because they believe that approach produces a more conservative result than the current acquisition cost approach by, among other things, eliminating what they believe would produce unsatisfactory results caused by dropping old costs and adding new costs of substantially similar items. They believe the reconstructed cost approach is consistent with the single pool concept and prevents potential manipulation of income, particularly if the link chain technique is used. Moreover, failure to reconstruct cost results, in effect, in a retroactive adjustment of the LIFO index. Further, they believe that approach is consistent with the LIFO objective because it facilitates retention of earliest costs in inventory.

4-27. Advisory Conclusion. The task force believes (9 yes, 0 no) that if the double extension or an index technique is used, the objective of LIFO is achieved by reconstructing the base year cost of new items added to existing pools. The base year cost of the new item should be estimated if it is not otherwise objectively determinable. The task force observes that if the link chain technique is used, reconstruction of prior years' costs is unnecessary because that technique produces approximately the same results as reconstruction. (Paragraphs 4-28 to 4-39 discuss the substitute base year technique, another alternative.)

4-29. Arguments. The arguments for and against disclosing the way new items are priced are essentially the same as the arguments for and against disclosing the LIFO approach used in paragraphs 2-7 and 2-8 of this paper.

4-30. Advisory Conclusion. The task force believes (8 yes, 1 no) the way new items are priced need not be disclosed.

4-32. Issue. What should be the guidelines for determining reconstructed cost?

4-33. Advisory Conclusion. The task force believes (9 yes, 0 no) reconstructed costs should be based on the most objectively determinable sources available, such as (in order of objectivity): published vendor price lists, vendor quotes, and general industry indexes.

In light of those situations, a technique has been developed in practice, commonly called substitute base year, in which the beginning of year's costs some year after the original base year (now referred to as the substitute or updated base year) are used instead of the original base year's costs to determine changes in dollar value LIFO pools. The procedure for establishing a new base year is not difficult. Older LIFO layers are retained, but the indexes are expressed as a percentage of the updated base year. For example, the LIFO index for an earlier year might be 72% of the updated base year. After updating the base year, a similar calculation would be made using costs as of the updated base year, and the lower indexes would be applied to preserve the older layers or to measure the amount of any decrements. In practice, the substitute base year technique has generally been applied, using the earliest base year alternative. That approach is predominant because the tax rules generally require its use. The IRS has been very restrictive in recent years in allowing companies to use the substitute base year alternative when LIFO accounting method changes are requested. Because of the strict tax conformity rules in effect prior to 1981 and the complexities of using different methods for book and tax purposes, the accounting treatment for books has followed the tax application. Appendix VI illustrates application of the substitute base year technique.

4-35. Issue. May companies use the substitute base year technique for financial reporting purposes?

4-36. Arguments. Some believe a company may use the substitute base year technique for financial reporting purposes because it represents a reasonable approach in situations in which it is impractical, if not impossible, to reconstruct base year costs. They believe it is consistent with the objective of LIFO. Others believe a company should not use the substitute base year technique for financial reporting purposes because they believe it is inconsistent with LIFO's objective and the expected results of using the substitute base year technique might differ from the results of reconstructing the base year costs. However, supporters feel the difference does not make the substitute base year technique inferior.

4-37. Advisory Conclusion. The task force believes (9 yes, 0 no) a company may use the substitute base year technique for financial reporting purposes.

4-39. Application of the two methods may be demonstrated as follows. Assume an ending inventory comprising five finished products (raw materials and work in process omitted in the interest of simplification):

Under the unit cost method, the index is determined by double extending the base year cost of all or a representative number of these products. The resulting index is then applied to the full dollar value of ending inventory to determine base year cost for the full inventory.

4-40. Under the cost component method, the inventory is disaggregated in terms of the underlying material, labor, and overhead content as follows:

The index is determined by relating the current year costs of inventory components with the base year or beginning of year costs of the same inventory components if link chain is used. As under the unit cost method, the resulting index is then applied to the full dollar amount of ending inventory to determine base year or beginning of year cost for the entire inventory.

4-41. The cost component method is well suited for use by manufacturers under various circumstances including the following:

• Manufacturers that use a job order cost system to account for inventories but cannot determine a unit product cost for a comparable product, because products are manufactured to order, not for shelf sale.
• Manufacturers of products that contain the same or very similar material ingredients, but are heavily influenced by fashion trends, for example, manufacturers of women's clothes.
• Manufacturers whose product lines are based on the same or similar raw materials but constantly evolve to reflect technological changes of various types or changes in customers' requirements, for example, chemical manufacturers.
• Manufacturers that experience continuing evolution as to making versus buying the various material ingredients of their finished products.
• Manufacturers with substantial work in process inventories in which comparability of unit cost from year to year would be lacking.
• Manufacturers with significant swings in production volume from period to period.

4-42. The following illustrates the effect of using the components of cost as the item rather than the finished product:

4-43. The above indicates that product specifications were changed. In 19X4, the quantity of processing time was reduced from 2 hours to 1½ hours and less of Ingredient A was used. If the company used components of cost as the item rather than units of finished product, the double extension computation would have been as follows:

Current year's index = $1,060,000/$780,000 = 135.90%

The LIFO cost of the inventory using this approach at December 31, 19X4 would be:

4-44. Because of the frequency of technological and other changes in finished products (for example, using less materials), using components as the item rather than the finished product is more likely to achieve the objective of charging to income the most recently incurred costs. It also results in a lower LIFO cost for the inventory and, of course, greater tax benefits. In the above, the company might have contended that the items in the 19X4 inventory should be considered a new item entering the inventory for the first time because of the significant changes in its components. Under that view, the company would have been entitled to reconstruct a new base year cost as follows:

4-45. Those calculations show the results would be the same whether the company used the components of the finished product or determined their costs individually. Appendix II to this paper presents another illustration of the cost component method.

4-46. Issue. May either cost component method or the unit cost method be used for calculating the change in the dollar value LIFO index?

4-47. Arguments Favoring the Cost Component Method. Arguments favoring the cost component method follow.

1. If the unit cost of finished product is not routinely developed as part of the cost accounting system, the cost component method is the only practical and reliable method to use to develop a LIFO cost index.
2. If styles constantly change, it is impossible to develop comparable base year costs. However, the comparable base year cost of the underlying material, labor, and overhead components will generally be readily determinable. Thus the resulting LIFO index will be much more representative and reliable than an index developed on the basis of theoretical base year costs.
3. The same rationale applies if the product line continually evolves, for example, with manufacturers of paints, plastics, and textile fiber yarns. For such manufacturers, makeups of finished products may have hundreds or even thousands of variations, but relatively few material ingredients, resulting in a greater degree of consistency and comparability in calculating the index if the cost component method is used.
4. Manufacturers that have significant changes in purchased, as opposed to produced, material ingredients can experience significant fluctuations in unit cost unrelated to the effects of inflation. Use of the unit cost method in such cases would cause meaningless index fluctuations.
5. The degree of utilization of manufacturing capacity can have a significant effect on the unit cost of finished products from period to period wholly apart from any change in underlying costs. Unit costs would generally decline when capacity utilization increases, and would generally increase when capacity utilization declines — even though the cost of material, labor, or overhead components remains unchanged. Use of the unit cost method under these conditions could produce a LIFO charge or a LIFO credit wholly unrelated to the effects of changing prices.
6. The cost component method is well suited to use with the link chain technique to avoid the problems encountered with identification of and accounting for "new products" or the reconstruction of base year cost for such products.
7. Proponents also believe the principles of LIFO accounting are not violated by the index determination and LIFO adjustment resulting from eliminating manufacturing efficiencies. They believe the goal of LIFO is to factor the effect of price changes out of inventories and this can be accomplished best by factoring it out of the underlying cost components rather than the unit cost of finished product, which is influenced by many other factors such as capacity utilization, technological changes, manufacturing efficiencies, product styles, and so forth.
8. Proponents also believe the cost component method is the only practical method to use if substantial work in process inventories exist. They cite the difficulties of double extending unit costs for in process inventories at various stages of completion.

4-48. Arguments Opposing the Cost Component Method. Arguments opposing the cost component method follow.

1. Some believe the cost component method should not be used because labor and overhead are intangible and do not represent physical components of the finished product inventory. Those who disagree point out that the same elements of labor and overhead are integral parts of the unit cost of finished product and that if they are valid inventoriable costs under the unit cost method, they are equally valid inventoriable costs under the cost component method.
2. Some believe the cost component method can cause ending inventory to be written down below its beginning of year cost as determined under the unit cost method.
3. Some criticize the cost component method because it can theoretically cause writing down the ending inventory below its base year cost as determined under the unit cost method when manufacturing efficiencies occur (fewer inputs of material, labor, or overhead required to produce same number of finished products). Proponents of the cost component method believe such situations are likely to be exceptional and to have an immaterial effect. Also they point out that there are likely to be offsetting inefficiencies resulting from environmental requirements, union work rule changes, and so forth, that would negate the effects of technological improvements.

4-49. Advisory Conclusion. The task force believes (9 yes, 0 no) either the unit cost or cost component method may be used for financial reporting purposes but that in certain circumstances, such as those discussed in paragraph 4-47, the cost component method may be preferable to the unit cost method, unless base year costs are reconstructed.

330-10-30 (Q&A 18) Change From Unit Cost Method to the Cost Component Method

5-2. If a LIFO inventory liquidation occurs, the LIFO method in part matches costs incurred in prior periods with current revenues. (In the above illustration, cost of sales includes some units at current cost, $1 a unit, some units at 19X4 costs, $.50 a unit, and some units at 19X2 cost of $.25 a unit). The SEC staff (Staff Accounting Bulletin Topic 11, paragraph 7806) requires the effects on income of LIFO inventory liquidations to be disclosed, either in the notes or parenthetically on the face of the financial statements.

5-4. Arguments. Some believe the effects on income of LIFO inventory liquidations should be disclosed because such information is necessary for readers to evaluate earnings from operations, because they believe inventory liquidations are infrequent. In fact, some believe APB Opinion 30 requires disclosure of the effects on income of LIFO inventory liquidations as "infrequent in occurrence or unusual in nature, but not both." Also, they point out the SEC staff requirement of that disclosure (Staff Accounting Bulletin Topic 11F). In addition, they believe disclosure indicates the extent to which LIFO does not result in matching current costs with current revenues.

5-5. Others believe the effects on income of LIFO inventory liquidations need not be disclosed because such liquidations are the expected result of applying LIFO when inventory levels decline. They believe it is the proper flow of the latest inventory cost incurred, regardless of the period acquired.

5-6. Others also believe disclosing the effects on income of LIFO inventory liquidations is the same as disclosing inventory profits, because they both result from matching prior period costs with current revenues. Some believe, however, this argument is irrelevant because inventory profits differ from inventory liquidations. Inventory profits are inevitable when FIFO is used in periods of rising prices, while LIFO inventory liquidations may or may not occur depending on inventory levels. They believe the effects on income of LIFO inventory liquidations should only be disclosed if all companies were required to disclose the portion of their costs that are not current costs. Others also believe disclosure of the effects on income of LIFO inventory liquidations is unnecessary because many companies are already required by FASB Statement No. 33 [superseded by FASB Statement No. 89, Financial Reporting and Changing Prices] to provide current cost information on a comparable basis for both LIFO and FIFO companies. However, some disagree because this information is not part of the primary financial statements, is not well understood by many users, and is not required of all companies.

5-7. Still others believe that any form of disclosure of the effects on income of LIFO inventory liquidations may be misleading because it implies that the "quality of income" is lower for LIFO companies that experience inventory liquidations than for comparable FIFO companies. This is not necessarily so. LIFO companies with inventory liquidations still may have higher costs of sales and lower earnings than comparable FIFO companies. For that reason, they believe the best measure of comparability for all companies is the current cost disclosure required by FASB Statement No. 33 [superseded by FASB Statement No. 89, Financial Reporting and Changing Prices], and in light of that disclosure, separate disclosure of the effects on income of LIFO inventory liquidations may be misleading and should not be made.

5-8. Advisory Conclusion. The task force believes (8 yes, 1 no) the effects on income of LIFO inventory liquidations should be disclosed.

5-10. Arguments. Some believe disclosure in the notes is adequate to warn the reader that a portion of cost is unrelated to the current year. They further believe liquidations are not necessarily infrequent nor unusual but that for many companies liquidations in LIFO inventories are common. Others believe special treatment should be given to the effects on income of LIFO inventory liquidations on the face of the income statement to highlight what they believe are unusual events for LIFO users. Of those who believe special treatment should be given in the income statement to the effects on income of LIFO inventory liquidations, views differ on whether the effects should be reported as (a) special line items that are unusual in nature or infrequent in nature but not both or (b) as extraordinary items.

5-11. Advisory Conclusion. The task force believe (9 yes, 0 no) disclosure in the notes of the effects on income of LIFO inventory liquidations is sufficient and that the effects should receive no special treatment in the income statement.

5-13. Arguments. Many companies that have a LIFO inventory liquidation ultimately replace the liquidated inventory. Some believe a replacement reserve should be provided because a replacement reserve would cause current costs to be matched against current revenue even in years in which there is a LIFO inventory liquidation. That, they believe, is consistent with the LIFO objective. Further, they believe a replacement reserve would make income statements more comparative by eliminating extraneous credits to cost of sales and the related balance sheet credit would be shown on the right side of the balance sheet. Also, they view the income statement effects of LIFO to be far more important than its balance sheet effect. Some believe replacement reserves should be provided only if it is probable that the inventory will be replaced.

5-14. Others believe a replacement reserve should not be provided because that approach is an inappropriate attempt to integrate current cost accounting into historical cost financial statements. LIFO is a matching of costs most recently incurred (not necessarily current year's costs) and current revenues and theoretically such a reserve would be conceptually inconsistent with LIFO's objective. Further, they believe a replacement reserve could violate the LIFO conformity requirement and could distort the carrying amount of the inventory on the balance sheet. They point out that theoretically a company that provides a replacement reserve could have a credit balance for inventory, if the reserve is to be offset against inventory.

5-15. Advisory Conclusion. The task force believes (8 yes, 1 no) a replacement reserve should not be provided if there is a LIFO inventory liquidation at year end.

5-17. Issue. Should the effects on income of involuntary LIFO inventory liquidations intended to be replaced be deferred at year end?

5-18. Arguments. Some believe the effects on income of such LIFO inventory liquidations should be deferred even if the effects of normal liquidations are reflected in income, because an involuntary liquidation results from temporary external circumstances and the enterprise intends to replace the liquidated layer as soon as practicable. They believe this effectively is a one time change from LIFO to FIFO and back again to LIFO. They believe a year end replacement reserve eliminates that disparity. Other arguments that support that treatment are essentially the same as the arguments developed in paragraphs 5-13 and 5-14 of this paper.

5-19. Others believe the effects on income of such LIFO inventory liquidations should not be deferred. Arguments against deferral are essentially the same as the arguments developed about replacement reserves in paragraphs 5-13 and 5-14 of this paper.

5-20. Advisory Conclusion. The task force believes (8 yes, 1 no) the effects on income of involuntary LIFO inventory liquidations should not be deferred at year end.

The following illustrates the alternatives using the specific goods approach. (The results would be similar if the dollar value approach was used.)

Inventory Liquidation:

1. Inventory Reinstatement — Normal Pricing Convention
   
   Since the liquidated units would have been stated at 19X2 cost of $7 if there had been an increment, the difference between $7 and the actual carrying amount charged to cost of sales represents the effect of liquidation. This result implies that the cost of all 280 units shipped should have been at $7 or $1,960, though only 200 units were acquired at that amount.
2. Beginning Reserve Reversal
   
   The reserve applicable to the units liquidated represents the layer liquidation. This method reflects the cost of sales reduction resulting from use of inventory at lower than the end of prior year costs.
3. Layer Reinstatement — At Year End Replacement Cost
   
   This method shows the result, assuming the end of 19X2 replacement cost of $7.20.

5-22. The method of disclosing the effects on income of LIFO liquidations was established by the IRS in 1976 (Revenue Procedure 76-7) and superseded in 1977 (Revenue Procedure 77-33). The IRS said the computation "must be made on the same basis employed by the taxpayer in actually valuing its LIFO increments" (method (a) in paragraph 5-21). In addition, the IRS prescribed the following acceptable footnote.

Since then, because of the LIFO conformity rules, companies have been following the IRS guidelines. In 1981, the IRS relaxed its interpretation of the conformity requirements (see section seven of this paper). While the new rules did not specifically withdraw the Revenue Procedure, the task force understands that companies need not follow it. Accordingly, the method of determining the effects on income of LIFO inventory liquidations for financial reporting purposes could be reexamined.

5-23. Issue. How should the effects on income of LIFO inventory liquidations be measured?

5-24. Arguments. Some believe the effects on income of LIFO inventory liquidations should be based on inventory reinstatement using the company's normal pricing convention, because they believe that approach is objective and reasonable and matches most recently incurred costs and revenues. They point out that this approach was once required by the IRS and widely used for financial reporting purposes.

5-25. Others believe the effects on income of LIFO inventory liquidations should be based on the beginning LIFO reserve credited to income, because the amount disclosed would represent the reversal of prior years' charges to income. They believe that approach is conceptually consistent with, and therefore analogous to, the disclosure requirements relating to other reversals of amounts previously charged to income (for example, warranty liabilities) under present historical cost accounting. Those who hold that view also point out that the disclosure relates to actual amounts recorded in the financial statements rather than a "what if" (pro forma) calculation. Opponents of that view believe the LIFO reserve is not analogous to a warranty obligation since, conceptually, a LIFO reserve represents the difference between the LIFO pricing method and one of many other inventory pricing methods. Accordingly, it is not, as the proponents suggest, a recorded or actual amount being reversed to income.

5-26. Still others believe the effects on income of LIFO inventory liquidations should be based on the amount of the replacement cost at year end, because that is the amount most representative of the costs to be incurred to replace the inventory.(This approach could produce approximately the same results as the first approach discussed if end of year costs were used.)

5-27. Advisory Conclusion. 8 task force members support a reinstatement approach, while 1 member supports the reserve credited to income approach. If the reinstatement approach is used, 7 task force members believe the inventory should be reinstated using the company's normal pricing convention, while 2 task force members believe the layer should be reinstated at the replacement cost of ending inventory.

5-29. Arguments. Some believe only pools with decrements should be given effect to, because a LIFO inventory liquidation in any pool causes prior costs to be charged against current revenues. They believe the liquidation effects of certain pools should be disclosed without netting increases and decreases. Further, they believe the effect disclosed should not be offset by the price change effect on that or any other pool.

5-30. Others believe decrements of pools should be netted against increments of other pools because an inventory liquidation is only one of several effects of LIFO. The netting effects are similar to the netting effects within a pool itself. They believe that since other disclosures ordinarily are based on consolidated amounts, so should disclosures of the effects of liquidations. Further, if the pools are similar, the same results could be obtained by combining these pools without having to disclose the effects. The following exhibit provides an illustration in which two separate pools, one with a liquidation, are combined into one pool resulting in about the same net LIFO provision but with no liquidation profit.

5-31. Advisory Conclusion. The task force believes (8 yes, 1 no) if the effects on income of LIFO inventory liquidations are disclosed, the disclosure should give effect to only pools with decrements.

5-33. Issue. Should the effects on income of such LIFO inventory liquidations be reported as part of the gain or loss on the disposal (not necessarily a discontinued segment of the business under APB Opinion 30)?

5-34. Arguments. Some believe the effects on income of such LIFO inventory liquidations should be reported as part of the gain or loss on disposal of a business, because they believe the effects on income of LIFO inventory liquidations arising from the sale of the segment are unrelated to normal business operations and therefore are not part of the cost of sales. Further, they believe the inventory stated at LIFO is the proper amount to be compared to the proceeds in computing gain or loss.

5-35. Others believe the effects on income of LIFO inventory liquidations, even if triggered by the disposal of a business, are still similar to other sales of inventory and, therefore, should be included in the cost of sales, whether the inventory is presented at LIFO or FIFO.

5-36. Still others believe, regardless of the circumstances and regardless of the inventory method used, the costs associated with inventory sold should be treated as part of the cost of sales.

5-37. Advisory Conclusion. The task force believes (9 yes, 0 no) the effects on income of LIFO inventory liquidations resulting from business disposals should be reported as part of the gain or loss from disposal of the operations.

If a company uses dollar value LIFO for its inventories, determining the LIFO cost of an individual item may be difficult. And, the company might decide it is more appropriate to apply the lower of cost or market rule to the total amount of each pool. Companies, in practice, may also consider combining pools in certain instances depending on the nature of their businesses. The following discussion, for simplicity, deals with the issue of individual items in a single pool versus aggregating the total of that pool. Aggregating pools for determining the lower of cost or market is discussed in the next issue.

6-2. The following illustrates the application of the lower of cost or market rule to dollar value LIFO inventories: XYZ Company uses the double extension, dollar value approach to price its LIFO inventory with a single pool comprising the following elements at the end of the year.

6-3. If the lower of cost or market rule is applied in the aggregate for all items within the LIFO pool, no market adjustment is required because the aggregate LIFO carrying amount ($130,000) is less than market ($145,000).

6-4. However, if the rule is applied item by item (or group of items), a market adjustment appears to be required. A basic question is how the amount for such an adjustment should be determined.

6-5. One allocation approach is to use a weighted average of the base year and total LIFO cost ($130,000/$125,000 = 104%) to determine LIFO cost by item. Assumed LIFO cost would be:

In this illustration, a market reserve is necessary for items B, C and D since their assumed cost is more than market value.

6-6. Another allocation approach is to use the ratio of total LIFO to FIFO cost to determine the LIFO cost by item. Under this approach, the LIFO cost of the four items would be determined by multiplying FIFO cost by 130/150.

A market reserve in this example is necessary for item D (but not B or C). This method could be used by a company that uses the link chain or cost component methods (whereas the first allocation method could not be) as well as any other LIFO method. While the market reserves differ under the two methods, this is expected since the allocation is by necessity arbitrary.

6-7. Another approach is to make the LIFO calculations with and without each of the individual items and to assume that the incremental differences represent the LIFO carrying amounts for each item to be compared with the market value for each item.

6-8. Issue. Should the aggregate or item by item approach be used in applying the lower of cost or market rule to a LIFO pool?

6-9. Arguments. Some believe the aggregate approach is the more practical approach, because determining the lower of cost or market item by item could be too costly, could require too much detailed recordkeeping, and would require an arbitrary allocation to determine cost. Further, they believe dollar value LIFO is an overall approach, which is inconsistent with an item by item approach. They also point out that for most companies LIFO is substantially below current cost in the aggregate and, therefore, it is inappropriate to further reduce the LIFO carrying amount for specific items. Further, the income statement under LIFO reflects current costs and therefore no additional charges by individual items are necessary to properly report income. Thus, the balance sheet is stated conservatively and the income statement is at current cost as a result of using LIFO; therefore, recording market reserves for items within a pool is not meaningful. ARB No. 43 also permits aggregating when appropriate and doing this within a pool is consistent with the guidance set forth in the ARB. ARB No. 43's approach to the lower of cost or market rule was balance sheet oriented and may not be as relevant for measuring income when LIFO is used.

6-10. Others believe an item by item approach, while perhaps more costly, is more theoretically sound and more conservative than the aggregate approach. Also, some infer from paragraph 13 of ARB No. 43, Chapter 4 a preference by the Committee on Accounting Procedure for the item by item approach.

6-11. Others support the aggregate of the pool approach but point out that in certain circumstances writedowns of specific items within a specific pool might be appropriate. For example, if an item becomes obsolete or will be abandoned, a writedown should not be precluded because the company uses the aggregate approach. They note that ARB No. 43 permits an item by item approach. Further, some believe using the item by item approach should be mandatory in these circumstances.

6-12. Advisory Conclusion. The task force believes (9 yes, 0 no) the most reasonable approach to applying the lower of cost or market provisions of ARB No. 43 to LIFO inventories is to base the determination on reasonable groupings of inventory items. Further, the task force believes that in general a pool constitutes a reasonable grouping. However, it believes the authoritative accounting literature permits the item by item approach, particularly for identified product obsolescence and product discontinuance. AcSEC agrees the authoritative accounting literature permits the item by item approach and further believes (12 yes, 1 no; task force: 1 yes, 8 no) the item by item approach should be used for identified product obsolescence and product discontinuance.

6-13. Issue. May a company aggregate more than one pool to apply the lower of cost or market test?

6-14. Arguments. Some believe it is appropriate in some or all cases to aggregate all inventory pools in applying lower of cost or market test. They point out that ARB No. 43, Chapter 4, Statement 7 states, "Depending on the character and composition of the inventory, the rule of cost or market, whichever is lower may properly be applied to each item or to the total of the inventory (or, in some cases, to the total of the components of each category) [emphasis added]." Those who support full aggregation note that Statement 7 also states that, "The purpose of reducing inventory to market is to reflect fairly the income of the period." They believe that, under LIFO, income for the period is fairly determined by matching most recently incurred costs against current revenues. Thus the need for inventory writedowns (except for obsolete or discontinued products) is obviated. Those who take this view acknowledge that inventory writedowns are appropriate to the extent that total LIFO inventory cost exceeds market. They point out, however, that for many companies that have used LIFO for a long time during periods of significant price changes, total LIFO cost may be substantially below market. In such cases, inventory writedowns for portions of the inventory would, in their view, both distort income and understate reported inventory amounts.

6-15. Others believe that while there may be conceptual merit in that approach, it is also necessary or desirable to have either a vertical or horizontal product line linkage to support aggregation of LIFO pools for the lower of cost or market test. They believe that approach most nearly complies with the spirit and intent of ARB No. 43. Some who support partial aggregation also point out that companies using many relatively small product line LIFO pools could, if they wished, aggregate several of these pools into fewer natural business units. Therefore, unless aggregation of such pools was permitted in applying the lower of cost or market test, writedown results could vary depending on whether companies used many small pools, or a few large pools.

6-16. Still others, however, believe any aggregation of pools is inappropriate in applying the lower of cost or market test. They cite this approach as more conservative. Also, they point to the statement in ARB No. 43, Chapter 4, Statement 7 that, "the most common practice is to apply the lower of cost or market rule separately to each item of the inventory." (Those who disagree with the item by item approach point out that when ARB No. 43 was written, FIFO and average cost were the predominant inventory accounting practices. Therefore, they do not view this statement as providing authoritative guidance under current circumstances.)

6-17. Advisory Conclusion. For companies having more than one LIFO pool, the task force believes (8 yes, 1 no) that if pools are similar (such as those involving an integrated product relationship or similar product lines), aggregating may be appropriate in applying the lower of cost or market test.

6-18. If, however, the compositions of the pools are significantly dissimilar, the task force believes (7 yes, 2 no) aggregating is inappropriate.

6-20. Discussion. Cost and market are generally compared in the aggregate for the item without regard to the cost of the individual increments. To illustrate:

In this illustration, even though the market has declined at the end of the year below the cost of year 2 purchases, no market reserve appears to be necessary since the total market value of $25,000 is in excess of LIFO cost. An issue arises, however, if the company anticipates a liquidation in year 3. For example, if the company plans to reduce its quantity to 14,000 units, cost of sales will be charged $9,000 (using the most recent purchases) and a loss on the sale will be likely. The issue is whether the loss should be recognized by providing a market reserve (that is [$1.50 – $1.25] × 6,000 units = $1,500) at the end of year 2.

6-21. Arguments. Some believe recording a loss on only certain of the units of a product in the inventory is inappropriate. The accumulation of cost by layer is a mechanical by-product of LIFO and is not intended to be used in determining the need for market reserves. The cost by layer for many different items in a pool is extremely difficult to compute and the result will probably require arbitrary allocations.Further, even if a liquidation is currently planned, its effect depends on future events, which may turn out significantly different.

6-22. Others believe expected losses should be recorded when they are probable and the amount is reasonably estimable.The LIFO method requires costing out the expected liquidation at most recent costs and if such cost is more than market there is an impairment which should be recognized.

6-23. Advisory Conclusion. The task force believes (7 yes, 2 no) lower of cost or market determinations under ARB No. 43 should be made for the total rather than by individual increments but if a company in its particular circumstances wished to provide a reserve by considering the cost of recent increments, it may do so.

One member of the Committee on Accounting Procedure objected to this footnote stating that "an exception should be made for goods costed on the LIFO basis."

6-25. Some have concluded that if the cost of LIFO inventories is reduced to market, ARB No. 43 indicates that the valuation reserve becomes part of the related LIFO layers (that is, not reversing until the layers are liquidated even after the related inventory giving rise to the reserve is sold). Others believe reserves should be reversed. Further, practice is inconsistent in this area.

6-26. Issue. Should previous writedowns to market value of the cost of LIFO inventories be reversed in subsequent years?

6-27. To illustrate the question of the accounting for market valuation reserves in subsequent years, the task force considered the following three situations (subissues). Each occurs in the year after a valuation reserve is provided:

1. Goods are sold at written down prices and not replaced. Other goods are acquired and therefore the total is not reduced.
2. Before the goods are sold, market value returns to its original level. The company sells the goods at the normal price and replaces the inventory.1
3. Goods are sold and market value does not return to previous level but the company replaces the inventory at the reduced market price.1

To illustrate: XYZ Company, Inc. sells several similar models of its basic product but maintains one LIFO pool. Quantity levels have remained constant since the base year. Because of changing consumer preference, sales of Model X decreased significantly and XYZ expects to sell its remaining inventories of Model X at well below cost. The following is the 19X1 LIFO calculation and relevant market value information:

The company records a market valuation reserve of $240,000 ($280,000 – $40,000) for product X. (The issue is easier to illustrate by using an individual product approach for determining the reserve rather than the aggregate of the pool approach and by assuming there have been no increments, that is, LIFO cost and base year cost are the same.) Thus, inventory at December 31, 19X1 is reported at $390,000 ($630,000 – $240,000).

The following illustrates the three situations for 19X2:

6-28. Subissue (a): Goods are sold at written down price. In 19X2, XYZ sells all Model X inventory at $10 a unit and discontinues buying that model. The company maintains the same overall unit level of inventory and does not experience a liquidation. 19X2 cost remains at $100 a unit for all other models. The following illustrates XYZ's 19X2 results under two alternatives.

6-29. Arguments. Supporters of reversing the reserve believe the market reserve should be associated with the physical units of inventory. They point out that if it is not reversed in 19X2, the loss is reported twice: once in 19X1 when the reserve is established, and again in 19X2, when the current cost of $400,000 is charged against sales of only $40,000. The total loss in 19X2 includes the previously recorded reserve of $240,000; in year two, if the reserve is not reversed, inventory will be reported at $390,000, which is neither cost nor market. Further, at the end of year 2, there is no reserve, because the cost of the inventory is less than market. In substance, after the units are sold, the reserve becomes a contingency reserve, which, under an FASB Statement No. 5 approach, should be reversed. Also, a valuation reserve differs from a writedown of the cost of the inventory.

6-30. The argument for not reversing the reserve is that the LIFO method is based on a flow of costs assumption and if there is no overall reduction in quantities, reversing the reserve contradicts that assumption and may be viewed as violating ARB No. 43. Supporters of reversing the reserve point out that ARB No. 43 was issued many years ago and might be viewed as balance sheet oriented. Current trends stress the income statement and, as the above illustrates, reversing the reserve in 19X2 provides more useful information for evaluating earnings.

6-31. Advisory Conclusion. The task force believes (9 yes, 0 no) that after a company disposes of the physical units of the inventory for which reserves were provided, it should reverse the reserve. The reserve at the end of the year should be based on a new lower of cost or market computation. The task force believes its advisory conclusion is an appropriate application of ARB No. 43.

6-32. Subissue (b): Market value returns to normal level in 19X2. In 19X2, the company in the illustration holds the 4,000 units of Model X; then the market value returns to a normal level; and Model X is then sold at its normal price. The following illustrates XYZ's results:

6-33. Arguments. Supporters of reversing the reserve argue that the units have been sold and therefore a reserve for those units is no longer needed. Supporters of not reversing the reserve make the same arguments as in the previous illustration and also note that in this illustration, since the market recovered, gross profit is properly stated in 19X2.

6-34. Advisory Conclusion. The task force believes (9 yes, 0 no) the disposition of units should result in reversing the reserve.

6-35. Subissue (c): Goods are sold at reduced price in 19X2 but are replaced. The company sold the 4,000 units of Model X at $10 a unit, renegotiates its purchase contract with its supplier to $10 a unit; and replaces the units sold. Model X can now be sold for $15 a unit. The following illustrates XYZ's 19X2 results:

6-36. Arguments. Again, the argument for reversing the reserve is based on the 4,000 units being sold and therefore the reserve for these units is no longer necessary. That the company continues to buy Model X does not affect this view because the units were disposed of and therefore the reserve is no longer necessary. Supporters of not reversing the reserve point out, in addition to the previous arguments, that at December 31, 19X2, the LIFO cost would inappropriately exceed market value if the reserve is reversed. In this oversimplified illustration, 6,000 units of Model X are again in the ending inventory with a LIFO cost of $70 a unit but a current cost of only $10 a unit. In contrast, supporters of reversing the reserve argue that a lower of cost and market valuation would be required to be made at December 31, 19X2 and a new reserve would be established based on current circumstances. They argue that this approach is practical, particularly in the usual situation of changing mix and quantities, and will result in a reasonable application of the lower of cost or market requirement.

6-37. Advisory Conclusion. The task force believes (9 yes, 0 no) reversing the reserve based on the flow of units in all situations and making a new lower of cost or market determination at the end of each year is appropriate.

6-39. Issue. How should the reversal of the lower of cost or market adjustment at the time of adopting LIFO be handled?

6-40. Advisory Conclusion. The task force believes (9 yes, 0 no) a consistent position on market reserves for companies using LIFO is desirable and that the advisory conclusion in paragraph 6-31 equally applies in the year LIFO is adopted, that is, reverse the reserve based on flow of goods in the year LIFO is adopted, and make a new calculation at year end.

7-2. To minimize conflict in this area, the IRS released in January 1981, regulations that softened its interpretation of the LIFO conformity requirement by permitting certain supplemental disclosures of non-LIFO information and by providing certain other guidelines that would not violate the LIFO conformity requirement. Those regulations are complex and require careful analysis.

7-3. The final regulations continue to require that the "primary presentation" on the face of the income statement must be prepared using LIFO, but the notes to the financial statements and other supplemental information may disclose the "pro forma" effects of using FIFO or some other acceptable inventory method. Further, the difference between the reported amount and current replacement cost of LIFO inventories may be disclosed in the balance sheet (as required by the SEC for companies that file their statements with it), and market value can be used for financial reporting purposes if it is lower than LIFO cost. Obviously, companies on LIFO should strictly adhere to the IRS regulations.

7-5. The SEC cautions companies in ASR No. 293 that supplemental LIFO disclosures must be considered carefully to avoid implying that FIFO earnings are the "real" earnings of a company on LIFO. The Commission believes FIFO-based supplemental disclosures by LIFO companies are not necessarily the best way to promote comparability of LIFO and FIFO companies but rather that the disclosures prescribed by FASB Statement No. 33 [superseded by FASB Statement No. 89, Financial Reporting and Changing Prices] is a better approach. The Commission further believes risk of user misinterpretation is mitigated when such disclosures are made, if companies that file their financial statements with the SEC also

1. state clearly that LIFO results in a better matching of costs and revenues,
2. indicate why supplemental disclosures are being provided, and
3. present essential information about the supplemental income calculation to enable users to appreciate the quality of the information.

In addition, the SEC believes if companies make such disclosures they should make them in the notes to the financial statements or in management discussion and analysis and not in financial highlights, press releases, or president's letter, because such analytical information normally is not presented in those places.

7-6. Issue. May a company present supplemental non-LIFO disclosures within the historical cost framework? (This issue presupposes disclosures would recognize the effects of, for example, the lower of cost or market rule.)

7-7. Arguments. Some believe a company may present such supplemental non-LIFO disclosures, because they believe such disclosures are useful for investors to compare companies in the same or similar industries that use different inventory methods. They point out that FASB Statement No. 33 [superseded by FASB Statement No. 89, Financial Reporting and Changing Prices] requires certain companies using FIFO to present as supplemental information earnings on a current cost basis. That is similar to presenting earnings on a LIFO basis as supplemental information.

7-8. Others believe a company should not present supplemental non-LIFO disclosures, because they believe that could detract from the information in the primary financial statements and could mislead users.They believe users could further be confused by allowing selected differential disclosures that are nonstandardized because of industry differences.

7-9. Advisory Conclusion. The task force believes (9 yes, 0 no) a company may present non-LIFO supplemental disclosures within a historical cost framework.

7-10. Issue. If a company presents supplemental non-LIFO disclosures within the historical cost framework, should computational guidelines be provided?

7-11. Arguments. Some believe computational guidelines should be provided to promote consistency and comparability. Others believe such guidelines should not be provided because supplemental information is not part of the basic financial statements and notes, which are the primary focus of generally accepted accounting principles. They also believe no computational guidelines should be provided for supplemental non-LIFO disclosures because no similar guidelines exist for other types of supplemental disclosures.

7-12. Advisory Conclusion. The task force believes (8 yes, 1 no) computational guidelines should be provided for supplemental non-LIFO disclosures.

7-13. Issue. If a company presents supplemental non-LIFO disclosures within the historical cost framework, what type of supplemental information should be disclosed?

7-14. Arguments. Views differ significantly on the type of supplemental information that should be disclosed (see paragraph 7-5(c) of this paper.) Some believe the disclosures required by FASB Statement No. 33 are adequate. As discussed earlier, the SEC, for one, supports FASB Statement No. 33 supplemental disclosures if certain other information is also disclosed.

7-15. Advisory Conclusion. The task force believes (8 yes, 1 no) companies providing supplemental non-LIFO disclosures should at a minimum disclose the information discussed in paragraph 7-5 of this paper. However, AcSEC believes (10 yes, 3 no) companies providing Supplemental LIFO disclosures need not at a minimum disclose the information discussed in paragraph 7-5, but believes (8 yes, 5 no) companies that present supplemental non-LIFO disclosures should not imply that non-LIFO earnings are their "real" earnings.

7-17. Issue. Should a company give effect to nondiscretionary variable expenses (for example, profit sharing based on earnings) in determining the income statement or balance sheet amounts similar to their consideration in presenting in the primary financial statements pro forma information regarding an accounting change?

7-18. Arguments. Some believe a company should give effect to nondiscretionary variable expenses because all nondiscretionary variable expenses that depend on measurements determined under generally accepted accounting principles should be adjusted for the change between LIFO and the non-LIFO method, which is required by APB Opinion 20, paragraph 19(d), for pro forma disclosures.

7-19. Others believe a company should not give effect to nondiscretionary variable expenses because they believe the primary emphasis should be on the difference between LIFO and the non-LIFO method, so only the inventory and cost of sales should be adjusted. They point out that the approach is similar to the selective adjustments to specified components of costs under FASB Statement No. 33 [superseded by FASB Statement No. 89, Financial Reporting and Changing Prices]. Further, they believe adjusting the amounts for all nondiscretionary variable expenses to reflect the change from LIFO to a non-LIFO method could confuse the reader. Further, comparisons between the LIFO and non-LIFO numbers would be meaningless since formulas ordinarily are changed if the measurements determined under generally accepted accounting principles are changed.

7-20. Advisory Conclusion. The task force believes (9 yes, 0 no) if it is probable that nondiscretionary variable expenses would have been different based on the supplemental information, the company should give effect to the changes in such nondiscretionary variable expenses. The task force's conclusion reflects the presumption that nondiscretionary variable expenses are based on existing formulas, unless disclosure is made to the contrary.

7-21. Issue. How should the income tax effect of a non-LIFO method be measured for supplemental income statement and balance sheet presentations? (An illustration follows)

7-22. Arguments. Some believe the current statutory tax rate should be used for simplicity, because they believe supplementary information normally would not include a complete separate set of financial statements. In addition, because the emphasis is on the current difference between LIFO and the non-LIFO method, the current rate is the most meaningful.

7-23. Others believe that, for comparability, essentially the same method should be used as that required by generally accepted accounting principles in the primary financial statements.

7-24. Still others believe no adjustment in income taxes should be made in supplemental disclosures because no adjustment is required under FASB Statement No. 33 [superseded by FASB Statement No. 89, Financial Reporting and Changing Prices].

7-25. Advisory Conclusion. The task force believes (9 yes, 0 no) the same type of tax effect required by generally accepted accounting principles in the primary financial statements should be used in determining supplemental disclosures of the after tax effects on pro forma net income and financial position.

7-26. Issue. Should the supplemental presentation reflect additional interest costs (or loss of interest income) as if deferral of taxes using LIFO had not been realized?

7-27. Arguments. Some believe the supplemental presentation should reflect additional interest costs as if deferral of taxes using LIFO had not been realized, because that is a primary result of using LIFO for tax purposes and its effect should be quantified.

7-28. Others believe the supplemental presentation should not reflect the additional interest costs as if deferral of taxes had not been realized, because to do so implies that tax deferral is the main reason for using LIFO. Also, since deferred taxes are not discounted, that which is, in essence, a timing difference should also ignore the time value of money (interest). Further, calculating additional interest costs would be arbitrary and hypothetical, because of the many subjective assumptions that would have to be made, such as the appropriate interest rate to use, the method and application of the interest rate, the timing of cash flows, alternate uses of funds, and so forth. Yet, others believe that though the assumptions may be hypothetical and arbitrary, they are based on the best information available and failure to make the calculation is more misleading than making none. They believe the burden is on those wishing to make supplemental disclosures to provide information that is neither misleading nor incomplete.

7-29. Advisory Conclusion. The task force believes (8 yes, 1 no) the supplemental presentation should not reflect additional interest costs from the loss of deferred taxes had LIFO not been used and believes disclosure of that fact need not be made.

7-30. Issue. How should the tax effects of the non-LIFO method be classified in the supplemental balance sheet (classified similar to deferred taxes, or as an inventory valuation account, or be considered a part of equity)?

7-31. Arguments. Some believe that for a non-LIFO method in which all components of expense have been adjusted, the income tax effect on the non-LIFO method should be classified as a separate component of equity, because it represents inventory holding gains deferred to future years.

7-32. Others believe that for a non-LIFO method, in which only inventory, cost of sales, and income taxes have been adjusted, the income tax effect should be treated as a timing difference because that is how the difference would be treated if a non-LIFO method were used for financial reporting and LIFO were used for tax purposes.

7-33. Advisory Conclusion. The task force believes (9 yes, 0 no) the difference is a timing difference and the effect should be classified in a manner similar to that required by generally accepted accounting principles in the primary financial statements.

7-35. While the IRS's relaxed interpretation of the LIFO conformity requirement permits alternatives in the LIFO used for financial reporting purposes, the method used must be in conformity with GAAP and consistently applied. Changes in inventory principles applied (whether initial adoption of LIFO or a change to a different LIFO method for financial reporting purposes) must be justified as preferable through the application of APB Opinion 20.

7-36. APB Opinion 20, among other things, requires an enterprise to justify as preferable use of the accounting principle. Examples of the major differences between financial reporting and income tax in LIFO applications now permitted by the IRS are:

• The way costs includible in the computation of inventory cost under the full absorption inventory method are determined.
• The way pools under the dollar value LIFO inventory approach are established.
• The way dollar value LIFO is computed, for example, by such techniques as double extension, index, and link chain.
• The way a price index to be used with the index on link chain techniques of stating inventory pools under the dollar value LIFO inventory approach is determined.
• The way current year cost of ending inventory in using the dollar value LIFO inventory approach is determined.
• The way cost of goods that exceed inventory at the beginning of the year in using a LIFO approach other than dollar value LIFO is determined.
• The time at which purchases and sales should be recorded.
• Use of an accounting period other than the period used for federal income tax purposes. (See separate section relating to this issue.)
• Use of cost estimates.
• The way intercompany sales and purchases are accounted for.

7-37. Other permissible differences are discussed in the IRS's January 1981 regulations. Use of any of the other permitted methods normally results in pretax income for financial reporting purposes different from that for income tax purposes.

7-38. Issue. May a company use for financial reporting LIFO applications different from those it uses for income tax purposes?

7-39. Arguments. Some believe a company should use for financial reporting the same LIFO applications it uses for income tax purposes. There is so little authoritative accounting literature on LIFO that the only way of determining an application's acceptability for financial reporting purposes is its acceptability for income tax purposes. Since any LIFO application is primarily an income tax method, there is no valid reason to use a different application for financial reporting purposes.

7-40. Others believe a company may use for financial reporting LIFO applications different from those it uses for income tax purposes because that would often produce more sound financial reporting.They point to the SEC's statement in ASR No. 293 that "for too long, LIFO financial accounting has been unduly influenced by tax rules..." In that release, the SEC encouraged companies to examine the practices they used to apply LIFO for financial reporting purposes and not necessarily follow the same practices used for tax purposes. In addition, some others believe that under the IRS regulations the LIFO applications a company uses for financial reporting must be acceptable for income tax purposes (though the company may use a different method on its own income tax return), so the argument against permitting different methods has no merit.

7-41. Advisory Conclusion. The task force believes (9 yes, 0 no) a company may use for financial reporting LIFO applications different from those it uses for income tax purposes. The task force further believes (9 yes, 0 no) accounting for income taxes applicable to the difference in pretax income resulting from the use of different LIFO applications for financial reporting and income tax purposes should be in conformity with generally accepted accounting principles for timing differences. Further, these differences should be accounted for as timing differences except for differences resulting from the allocation of cost to inventory in business combinations under APB Opinion 16 [superseded by FASB Statement No. 141, Business Combinations].

7-43. Arguments. Some believe differences between LIFO applications used for financial reporting and those used for income tax purposes should be disclosed because they believe that while that information normally is disclosed in the deferred income tax note, it may be overshadowed by other information in that note. And, they believe that information in the deferred income tax note may be insufficient in detail for users to fully understand the differences.

7-44. Others believe separate disclosure of differences between LIFO applications used for financial reporting and those used for income tax purposes should not be required, because they believe the information normally is disclosed in the income tax note, if material.

7-45. Other arguments for and against disclosing differences between LIFO applications used for financial reporting and those used for income tax purposes are essentially the same as the arguments for and against disclosing the LIFO approach used in paragraphs 2-7 and 2-8 of this paper.

7-46. Advisory Conclusion. The task force believes (9 yes, 0 no) differences between LIFO applications used for financial reporting and those used for income tax purposes need not be disclosed beyond the requirements of APB Opinion 11 [superseded by FASB Statement No. 109, Accounting for Income Taxes].

8-3. Issue. Should the estimate of the LIFO interim effect be based on (a) interim year to date LIFO calculations (except for liquidations expected to be reinstated or increments expected to be reversed by year end, which are discussed later in this paper), (b) an allocation of the projected year end LIFO calculation, or (c) separate discrete interim LIFO calculations? This issue does not cover timing of recognizing permanent inventory liquidations that have not occurred. Paragraphs 8-19 through 8-25 discuss that. (Appendix IV to this paper illustrates approaches (a) and (b)).

8-4. Arguments. Some favor approach (a) because they believe neither income nor expense should be recorded before it is realized or incurred. Prorating the effect of changing prices results in a failure to match most recently incurred costs to current revenues. They believe approach (a) is more consistent with the objective of LIFO, which they believe is valid for interim as well as annual reporting. They also believe financial reporting, even interim financial reporting, should account for the results of transactions and other events that have occurred, not that might occur. If approach (a) is used, paragraph 14 of APB Opinion 28 requires that interim earnings not reflect the effects of a liquidation expected to be reinstated by year end. Some would modify approach (a) slightly for temporary increments. (Appendix IV to this paper illustrates the application.)

8-5. Others favor approach (b) because they believe LIFO is intended to measure the effects of price changes over a year and, so, the effects should be spread over the year. They further believe that since interim LIFO calculations are costly and time consuming, approach (b) is more practical than approach (a). Further, estimating the effect of changing prices on inventories in process more frequently than yearly would be impractical, if not impossible. Use of approach (b) avoids the problem of accounting for LIFO inventory liquidations or increments expected to be reversed by year end. They believe approach (b) is supported by paragraph 14(b) of APB Opinion 28, which states that "companies that use the LIFO method may encounter a liquidation of base period inventories at an interim date that is expected to be replaced by the end of the annual period. In such cases, the inventory at the interim reporting date should not give effect to the LIFO liquidation, and cost of sales for the interim report period should include the expected cost of replacement of the liquidated LIFO base." Measurement of rates of inflation for periods shorter than a year may be subject to unrepresentative fluctuations. They believe the estimated effective rate of inflation, like the estimated effective rate of taxation, should be spread ratably over the full year. And, they believe other inventory methods, such as FIFO, standard cost, and average cost, do not require separate interim computations for overhead and standards.

8-6. Few, if any, support approach (c) for the reasons described in the background section of this issue.

8-7. Advisory Conclusion. The task force believes (9 yes, 0 no) only approaches (a) and (b) are acceptable as long as the application results in a reasonable matching of most recently incurred costs with revenues, considering such things as the effects of significant changes in prices, operating levels and mix.

330-10-30 (Q&A 19) LIFO Liquidation at Interim Reporting Period

330-10-30 (Q&A 20) Change in the Method of Calculating Interim Period LIFO Adjustments

8-9. Issue. How should the adjustment be treated for interim balance sheet purposes? Possible treatments include:

1. Record as a deferred credit in the current liabilities section of the balance sheet the pretax income effect of the LIFO inventory liquidation, with inventory reflecting the liquidation.
2. Record as a liability (perhaps included in accounts payable) an amount sufficient to reinstate the inventory balance to the amount before liquidation plus the amount necessary to offset the income statement liquidation effect.
3. Record as a credit to inventory (in rare circumstances the credit could be greater than the inventory balance), the effect of which in some cases is to do nothing.

8-10. The following illustrates the above possibilities:

The entire inventory is sold in a quarter but is expected to be replaced by year end. The company charged cost of sales with FIFO cost ($1,000) and credits inventory with the same amount so the balance sheet now reflects a $400 credit in the inventory account. The options for adjusting the balance sheet accounts are:

8-11. Arguments. Some favor the liability treatment, and some of them favor recording as a liability the net amount required to measure pretax income as if no liquidation had occurred. They believe it is, in effect, a deferral of the credit generated by the liquidation pending a determination at year end of whether it is temporary. They further believe it more properly reflects the inventory account balance, because there has actually been a reduction in inventory.

8-12. Others who favor the liability treatment favor recording as a liability the cost to replace the liquidated inventory, by charging income with the net amount and increasing the carrying amount of the inventory by the historical LIFO cost of the liquidated inventory, because they believe there is a liability to replace inventory. They further believe the liability treatment should be used because the transaction does not relate to the balance sheet carrying amount of inventory but rather to determining the appropriate charge to cost of sales. As a practical matter, they believe the liability treatment will be better understood by financial statement users who might otherwise conclude that a permanent LIFO inventory liquidation had occurred.

8-13. Others favor the inventory treatment because they believe the reserve should be viewed as a valuation account and offset against the inventory. They believe the "reserve" does not meet the definition of a liability under FASB Concepts Statement No. 3 [superseded by FASB Concepts Statement No. 6, Elements of Financial Statements]. They believe it is an adjustment of the overall LIFO concept and therefore should be reflected as part of inventory. They believe the arguments presented in paragraph 8-5 of this paper also support the inventory approach. Further, those using the projected annual LIFO cost approach (approach (b) discussed in paragraph 8-2) would not isolate the effects of temporary liquidations but would automatically reflect them in the inventory presentation.

8-14 Advisory Conclusion. While 7 task force members favor treatment (x) and 2 favor treatment (z), the task force believes (6 yes, 3 no) that, for practical considerations, either treatment (x) or treatment (z) is acceptable.

8-16. Issue. If companies using specific goods LIFO encounter inventory increments expected to be reversed by year end, should such increments affect interim LIFO computations?

8-17. Arguments. Arguments for and against recognition of inventory increments expected to be liquidated by year end under circumstances described in paragraph 8-15 are essentially the same as those discussed in paragraphs 8-4 and 8-5, except that a different approach would be needed to negate the recognition of such increments for companies using specific goods LIFO.

8-18. Advisory Conclusion. The task force believes (8 yes, 1 no) companies using specific goods LIFO should adjust interim costs if temporary interim inventory increments occur, to produce a reasonable matching of most recently incurred costs with current revenues.

8-20. Issue. Should the effect of an interim LIFO inventory liquidation not expected to be reinstated by year end be measured based on the liquidation to date or on the proration of the expected liquidation for the year?

8-21. Arguments. Most of the arguments are essentially the same as those developed for the issue on LIFO and interim financial reporting inparagraphs 8-4 and 8-5 of this paper. However, additional considerations are involved in this issue. Many aspects of interim reporting relating to allocation of costs are not specifically covered by existing accounting principles. As a result, the task force believes practice in this area is diverse. For example, companies using specific goods LIFO are generally able to determine when a liquidation occurs and recognize the effect at that time. Conversely, companies using dollar value LIFO and following approach (b) in paragraph 8-2 of this paper may include the anticipated effect of liquidations in their overall LIFO calculation and not attempt to identify during the year when liquidations take place. Some of these companies view the annual LIFO adjustment as the same as other types of annual charges that are allocated over interim periods on a rational and logical basis. For example, an effective annual income tax rate (including the effect of projected investment tax credits) is used in all interim periods; depreciation charges are often allocated ratably throughout the year; and, factory overhead rates are often applied on an annual basis. These companies believe it is appropriate to treat the effect of the anticipated liquidation as an integral part of the annual LIFO adjustment. Others believe spreading the effect of the liquidation on this basis is acceptable because the cost of attempting to identify the timing of when liquidations occur do not justify the benefits to be derived.

8-22. Advisory Conclusion. The task force believes (9 yes, 0 no) that to the extent it can be reasonably determined considering cost-benefit factors involved, a company should recognize the effect of an interim LIFO inventory liquidation not expected to be reinstated by year end in the period in which it occurs. However, the task force also believes (7 yes, 2 no) a company using dollar value LIFO and approach (b) described in paragraph 8-2 may spread the expected effect of the LIFO inventory liquidation using an approach similar to the one it uses for allocating the LIFO adjustment (normally a charge).

9-2. Issue. May a company whose financial reporting year end differs from its tax year end use for financial reporting purposes the LIFO calculation it uses for income tax purposes?

9-3. Arguments. Some believe the LIFO calculation a company uses for income tax purposes is also valid for financial reporting purposes and that a separate LIFO calculation for financial reporting purposes is unnecessary. (The LIFO charge for any given year for financial reporting purposes would consist of a proration of the LIFO charge used for income tax purposes for the tax year ending within the financial reporting year end and a proration of the estimated LIFO charge for the ensuing tax year.) Following are arguments in support of this position:

• The primary reason for adopting LIFO is to obtain the related income tax benefits. The tax LIFO calculation should therefore be considered acceptable for financial reporting purposes as well.
• Though short run LIFO results could vary if year ends for financial reporting and income tax purposes differed, over the long run the results tend to be about the same.
• Wide variations are possible among various acceptable methods of calculating LIFO. Since no approach has been proven superior, using for financial reporting purposes the LIFO approach used for tax purposes should be acceptable.
• Business judgment may dictate increasing inventory levels at certain times to avoid the adverse tax effect that would otherwise result from inventory liquidations not expected to be reinstated by year end. Using tax LIFO for financial reporting purposes would obviate the need to take similar action (which may involve additional cost) at some other time during the year to avoid reporting the higher earnings that would otherwise be the effect of temporary inventory liquidations.
• For most companies to maintain two separate LIFO accounting systems would be prohibitively expensive. This added cost cannot be justified though some may believe a separate book calculation would be theoretically superior. For a growing company the LIFO calculation used for financial reporting purposes could typically approximate the LIFO calculation used for income tax purposes.

9-4. Others believe if a company's year end for financial reporting purposes differs from its tax year end, there should be separate LIFO calculations, for the following reasons:

• The concept of a discrete fiscal year for financial reporting purposes is of overriding concern. The LIFO calculation for financial reporting purposes should be based on the inventory amount at the beginning and end of the financial reporting year.
• The LIFO calculations for financial reporting purposes could differ significantly from the LIFO calculations for tax purposes if inventory quantities varied substantially between the two year ends or if the trends of inventory costs changed considerably. Using for financial reporting purposes the LIFO calculations used for income tax purposes might produce unsatisfactory results under such circumstances.
• Financial and income tax accounting differ in many areas. This would be but one more.

9-5. Advisory Conclusion. The task force believes (8 yes, 1 no) a company whose financial reporting year end differs from its tax year end should make a separate LIFO calculation for financial reporting purposes using its financial reporting year as a discrete period for that purpose.

Accounting for Income Taxes, Temporary Differences — FASB Statement No. 109, paragraphs 10–15

9-7. Issue. If a company on LIFO is acquired in a business combination accounted for by the purchase method, in which the tax and book bases of the LIFO inventory differ, should the fair value of the inventory be adjusted for the income tax effects of the basis differential if inventory is not expected to be reduced below its acquisition level?

9-8. Arguments. Some believe the fair value of inventory should be adjusted, because providing for a difference in income tax bases in the inventory valuation is consistent with the requirements for valuing other assets acquired in a business combination accounted for by the purchase method. In fact, they point out that if bases differ and the inventory is worth less, the inventory should be presented at the lower amount. They further believe expectations of future events are inherently too uncertain to determine the appropriate basis for stating the inventories. Indeed, they believe demonstrating with reasonable assurance that inventory levels will be maintained or increased in the future is difficult if not impossible.

9-9. Others believe the fair value of inventory should not be adjusted, because APB Opinion 16 [superseded by FASB Statement No. 141, Business Combinations], which requires consideration of estimated future income tax effects in determining fair value, apparently also allows consideration of all the facts in a given situation, including the extent and timing of liquidations. They believe that since APB Opinion 16 [superseded by Statement 141] permits discounting, companies can discount the income tax effects to virtually zero if no liquidations are expected in the near future. Moreover, they believe there should be no accounting requirement to provide for the effects of events not expected to happen.

9-10. Advisory Conclusion. The task force believes (9 yes, 0 no) an adjustment should be made for the difference in the tax and book bases of LIFO inventory reasonably estimated to be liquidated. However, if near term a liquidation is not probable, such an adjustment is unnecessary because the discounted income tax effects are minimal. APB Opinion 16 [superseded by FASB Statement No. 141, Business Combinations]provides for those considerations.

9-11. Issue. If the LIFO method is adopted for the inventory of a company acquired in a business combination accounted for by the purchase method, should the acquired inventory be considered opening inventory or part of purchases for the year in determining the LIFO layers?

9-12. Arguments. Some believe the acquired inventory should be considered opening inventory, because they believe inventory acquired in a business combination is different, in substance, from goods acquired in the normal course of business.

9-13. Others believe the acquired inventory should be considered part of purchases, because they believe inventory acquired in a business combination is substantially similar to other items purchased for an existing pool and, accordingly, should be similarly treated.

9-14. Still others believe the controlling factor should be whether the acquired inventory is to be treated as a new pool or whether the items are similar to and will be combined with an existing pool. If the acquired inventory is to be combined with an existing pool, some believe that it is substantially the same as purchases of existing items for that pool. But, for a new pool, they believe the acquisition should represent the starting point for that pool.

9-15. Advisory Conclusion. The task force believes (8 yes, 1 no) if inventory of an entity acquired in a business combination accounted for by the purchase method is treated as a separate business unit or a separate LIFO pool, the acquired inventory should be considered the LIFO base inventory. If, however, the acquired inventory is combined into an existing pool, the task force believes (9 yes, 0 no) the acquired inventory should be considered as part of current year's purchases.

330-10-30 (Q&A 21) Inventory Added to Existing LIFO Pool as Part of a Business Combination

9-17. Examples of changes in LIFO applications include:

9-18. Issue. If a company on LIFO changes any of its LIFO applications (approach, computational technique, or the numbers or content of its pools), is such a change a change in an accounting principle under APB Opinion 20?

9-19. Arguments. Some believe a change in a LIFO application is a change in an accounting principle under paragraph 7 of APB Opinion 20 [amended by FASB Statement No. 111, Rescission of FASB Statement No. 32 and Technical Corrections]. Others believe the criteria in paragraph 8 of that Opinion are broad enough to preclude a change in a LIFO application from being considered a change in accounting principle. Still others believe the facts and circumstances surrounding the change in a LIFO application should be looked at to determine whether the change in a LIFO application was necessitated by transactions or events substantially different from those previously occurring.

9-20. Advisory Conclusion. The task force believes (8 yes, 1 no) a change in a LIFO application is a change in an accounting principle under APB Opinion 20 requiring disclosure of the effects of the change on current income unless the change in LIFO application is necessitated by transactions or events substantially different from those previously occurring.

330-10-30 (Q&A 22) Change in Index for Dollar Value LIFO Calculations

9-21. Issue. If a change in a LIFO application should be considered a change in an accounting principle, how should the change be recognized?

9-22. Background. APB Opinion 20, paragraph 18, provides that a change in an accounting principle should generally be recognized by including in net income the cumulative effect, based on retroactive computation, of changing to the new principle. APB Opinion 20 discusses several exceptions to the general rule; for instance, paragraph 27 (amended by FASB Statement No. 73, Reporting a Change in Accounting for Railroad Track Structures) of the Opinion holds that certain changes in accounting principles are such that the advantages of retroactive treatment in prior periods outweigh the disadvantages and, so, all prior periods should be restated. It cites a change from the LIFO method of inventory pricing to another acceptable method.

9-23. Further, paragraph 26 of APB Opinion 20 states that computing the cumulative effect of a change in an accounting principle may in rare situations be impossible. In those cases, the effect of the change on current period results of operations is disclosed only and an explanation for omitting the cumulative effect is given.

9-24. Arguments. Some believe that if a change in a LIFO application should be considered a change in an accounting principle, the change should generally be recognized by including in net income the cumulative effect, based on retroactive computation, of changing to the new principle.

9-25. Others believe that if a change in a LIFO application should be considered a change in an accounting principle, the advantages of retroactive treatment in prior periods outweigh the disadvantages and, therefore, all prior periods from initial adopting of LIFO should be restated.

9-26. Advisory Conclusion. The task force believes (9 yes, 0 no) if a change in a LIFO application is a change in an accounting principle, generally the effect of the change should be recognized in current net income because the cumulative effect, based on retroactive computation, of changing to the new principle generally would be undeterminable. However, if determinable, the cumulative effect from the time of adopting LIFO may be recognized in current net income as a cumulative catch up adjustment. The effect of the change should be disclosed in accordance with APB Opinion 20.

330-10-30 (Q&A 23) Reporting a Change in LIFO Application After Adopting Statement 154

9-28. This is a conceptual issue with many ramifications and is beyond the scope of this paper. However, the Task Force on LIFO Inventory Problems plans to develop a separate issues paper that will explore this issue.

The examples deal only with labor hours. In FIFO and double extension-product LIFO, the labor hours would be included in the total cost of the product. The effects, however, would be as shown.

The examples demonstrate that in the presence of an increase or a decrease in productivity, the difference between the FIFO inventory value and the cost component technique is the effect of inflation.

The double extension technique offsets the decreases in labor hours (productivity increase) against the increase in cost due to inflation.

In the presence of a productivity decrease (an increase in labor hours), the effect of double extension is to ignore the increase in labor hours.

The difference between the FIFO inventory amount and the double extension inventory amount consists of the inflation increase of $105 plus the increase caused by the increase in labor hours of $50. (Schedule B)

The cumulative FIFO inventory activity and results of operations are as follows:

Projected quarterly and year end calculations of LIFO using actual quarter-end inventories and projected annual inflation (index) are as follows:

The fundamental question is how to project and allocate the LIFO adjustment of $116. Some sort of pro rata allocation of annual (or projected annual) LIFO adjustments could be used (method B) or a separate quarterly calculation could be developed (method A). The following is a summary of results under these alternatives. For simplicity in the illustration above and the illustration of method A, it has been assumed that allocation of the annual results to the four quarters is performed after-the-fact or that information is known on a timely basis. As a practical matter such calculations are performed on a prospective basis, without benefit of hindsight. Methods B1, B2, B3, and B4 would require projecting the annual inflation rate and annual activity levels, which may be subject to greater estimation error.

Assume:

• Product priced to earn $3 / unit (gross margin).
• Purchases of 100 units each quarter.
• Units purchased and sold equal for full year, but unequal within year due to seasonal sales pattern.
• Opening inventory at January 1 of 100 units at $5.00 each unit, or $500 total.
• Increase of $2 / unit in purchase and selling prices on April 1.
• LIFO inventory method, with first purchase price approach to pricing increments, and temporary inventory increments calculated as if permanent.

Base Year Cost — the amount of current year's inventory converted to its cost in the year LIFO was adopted.

Conformity Requirement — an Internal Revenue Service code that requires a company that uses LIFO for income tax purposes to use LIFO for financial reporting purposes.

Cost Component Method — a method of applying dollar value LIFO in which changes in the LIFO index are measured by the weighted average increase or decrease in the component costs of material, labor, and overhead that constitute ending inventory.

Dollar Value — an approach to applying LIFO in which inventory items are grouped by pools and are priced in terms of each pool's aggregate base year cost. The result is compared with each pools' aggregate base year cost as of the end of the prior year to determine whether the inventory levels in each pool have increased or decreased.

Double Extension — a technique used in applying dollar value LIFO in which the current and base year costs of each item in inventory are extended, or multiplied, by the units on hand at the current year valuation date.

External Index — a technique used in applying dollar value LIFO in which the dollar value of ending inventory at current year prices is restated to approximate the base year prices using an index determined by an outside source, such as the Bureau of Labor Statistics Index.

Increment — an increase in inventory units (or total base year costs in a pool if dollar value LIFO is used) at the end of a year compared to those at the beginning of the year.

Internal Index — a technique used in applying dollar value LIFO in which the base year cost of ending inventory is determined by applying an index (based on a sample of current year costs to base year costs of items in inventory) to the dollar value of the ending inventory at current year cost.

Inventory Profits — unrealized increases in the amount of inventory held during periods of rising prices when the FIFO method is used.

Last In, First Out (LIFO) — an inventory method whose objective is commonly viewed as charging cost of goods sold with the costs of goods most recently acquired or produced.

LIFO Reserve — the difference between (a) inventory at the lower of LIFO cost or market and (b) inventory at replacement cost or at the lower of some acceptable inventory accounting method (such as FIFO or average cost), or market.

Link Chain — a technique used in applying dollar value LIFO in which the base year cost of ending inventory is determined by applying a cumulative index to the dollar value of the ending inventory. The cumulative index is the relationship of the current year prices to those of the prior year (based on either double extension or internal index) multiplied by the prior year's cumulative index, causing each year's index to be characterized as a link in a chain of indexes back to the base year.

Liquidation (sometimes called a decrement) — a decrease in inventory units (or total base year costs in a pool if dollar value LIFO is used) at the end of a year compared to those at the beginning of the year.

Natural Business Unit — a LIFO pool, used under dollar value LIFO generally comprising the entire production capacity of the enterprise integrated vertically within one product line, or two or more related product lines, including any material procurement, processing of materials, and selling the produced goods.

Pool — a group of substantially similar inventory items.

Reconstructed Cost — the amount at which items in inventory would have been priced if they had been acquired in the base year.

Replacement Cost — the current cost of replacing inventory or any reasonable approximation, which may be FIFO or average cost, at the lower of cost or market.

Specific Goods — an approach to applying LIFO in which changes in the quantity of individual types of inventory are the bases for determining whether inventory levels have increased or whether a portion of the existing inventory has been liquidated.

Substitute Base Year — a technique in which beginning of year costs in the year of change are used instead of the base year's costs to determine changes in dollar value LIFO pools.

Unit Cost Method — a method of applying dollar value LIFO in which changes in the LIFO index are measured by the weighted average increase or decrease in the unit cost of raw materials, work in process, and finished good inventories.