Essay: Integral part of financial statements

I. Introduction

Inventory had always been an integral part of the financial statements. The reported amount of inventory affects the cost of goods sold, gross profit and net income in the income statement. It also affects the assets and stockholder’s equity reported on the balance sheet. It is therefore, very crucial for investors and creditors who look at the financial statements of a company to know how inventory is valued. This helps these investors and creditors in determining the credibility of the company. Accounting practices has given certain level of freedom to firms in choosing accounting valuation methods. Inventory valuation is among them. The firms have been given the choice to use any of the valuation methods that they find suitable for their business. Most common among these inventory valuation methods are FIFO (first-in-first-out), LIFO (last-in-first-out), and weighted average and specific identification.

The focus of this paper is on the determinants of the choice of accounting inventory valuation between FIFO and LIFO. This paper examines why firms elect to choose FIFO over LIFO or LIFO over FIFO. For this paper, we ignore the determinants of why firms choose weighted average or specific identification method over FIFO and LIFO. The paper examines various reasons that firms look over to choose FIFO over LIFO.

The review of prior research suggests some reasons as to the choice of FIFO and why certain firms would have an incentive to change from LIFO to FIFO. This paper will integrate those reasons, which prior research had found, on the choice of LIFO inventory valuation method over the FIFO. Since most companies switch to LIFO over the course of their business, it is interesting to know firm’s reasoning behind this change. Is it only potential tax benefits that induce firms to make a change to LIFO valuation or are additional benefits from this huge transformation? What purposes lay behind this change and does earnings management play any role in those purposes?

Finally, the paper also discusses the concerns expressed by various heads of the companies about the proposed convergence of GAAP to IFRS. The concern is showed by the executives of those companies who use LIFO extensively for the calculation of their ending inventory. LIFO method is not permitted under IFRS and if the convergence happens, huge tax liabilities would be faced by the LIFO-user companies from LIFO liquidation and they would have to forgo those tax benefits that they enjoyed under LIFO.

The rest of this paper is divided as such: Section II describes the difference that exists between LIFO and FIFO by taking a hypothetical company and finding the ending inventory under both valuation methods.Section III provides the incentives that managers have in choosing the valuation method and provides reasons as to why they prefer one method over the other. Section V presents additional reasons as to why firms would forgo benefits under LIFO and use FIFO. Section VI presents examples of firms and companies that either switched their inventory valuation method from FIFO to LIFO or from LIFO to FIFO. Section VII provides evidence of time periods when firms are more likely to make a switch from one method to another. Section VIII presents the concerns of firms on the proposed convergence of GAAP to IFRS and the impact it would have on LIFO-users and Section IX concludes.

II. LIFO v. FIFO

This section describes the difference existing between FIFO and LIFO. As the names suggest, FIFO method assumes that items sold are those that were acquired first while LIFO method assumes that items sold are those that were most recently acquired. Let’s take a hypothetical company; company A, using FIFO method in the first case and company B using LIFO method in the second case.

Both companies began 2009 with $22,000 of inventory. The cost of beginning inventory is composed of 4,000 units purchased for $5.50 each. Merchandise transactions during 200 were as follows.

Table 1

Purchases
Date of Purchase	Units	Unit Cost	Total Cost
Jan 17	1,000	$ 6.00	$ 6,000
Mar 22	3,000	7.00	21,000
Oct 15	3,000	7.50	22,500
Totals	7,000		$ 49,500
Sales
Date of Sale	Units
Jan 10	2,000
Apr 15	1,500
Nov 20	3,000
Total	$ 6,500

2.1: FIFO Inventory Valuation Method

As mentioned above, this method assumes that the items sol d are those that were acquired first, followed by the purchases that occurred during the year in the chronological order of their acquisition. In the case of the data presented above, 2000 units that were sold on Jan 10 would decrease the beginning inventory of 4000 units by 2000, with beginning inventory coming down to 2000 units. The 1500 units that were sold on Apr 15 further reduce the beginning inventory to 500 units. Finally, the 3000 units sold on Nov 20 brings down the beginning inventory down to 0 and also reduces the purchase of Jan 17 and Mar 22 by 1000 and 1500, bringing down Jan 17 purchase to 0 and Mar 22 purchase to 1500. The ending inventory is the 1500 units remaining from Mar 22 purchases and 3000 units of Oct 15 purchases. This flow of FIFO is graphically presented below:

Table 2.1.1

Cost of Goods Available for Sale

Units Available
Beginning Inventory	4,000
Jan 17	1,000
Mar 22	1,500
Mar 22	1,500
Oct 15	3,000
Total	11,000

6,500 units sold

4,500 units in ending inventory

We can now find the ending inventory and cost of goods sold from the above data as follows:

Table 2.1.2

Cost of Goods Sold

Date of Purchase	Units	Unit Cost	Total Cost
Beginning Inventory	4,000	$ 5.50	$22,000
Jan 17	1,000	6.00	6,000
Mar 22	1,500	7.00	10,500
Total	6,500		$ 38,500

Table 2.1.3

Cost of Ending Inventory

Date of Purchase	Units	Unit Cost	Total Cost
Mar 22	1,500	$ 7.00	$ 10,500
Oct 15	3,000	7.50	22,500
Total	4,500		$ 33,000

Table 2.1.4

Summary

Beginning Inventory (4000 units @ $5.50)	$ 22,000
Plus: Purchases (7,000 units from Table 1)	49,500
Cost of Goods Available for Sale (11,000 units from Table 2.1.1)	71,500
Less: Ending Inventory (4,500 units from Table 2.1.3)	(33,000)
Cost of Goods Sold (6,500 units from Table 2.1.2)	$ 38,500

2.2: LIFO Inventory Method

This method assumes that units sold are the most recent units purchased. In this case, 6,500 units that were sold would reduce the purchase of Oct 15 by 3000 units, and then reduce the Mar 22 purchase by 3000 units and finally would reduce the Jan 17 inventory by 500 units. The difference that we observe here is that instead of reducing beginning inventory first, we actually reduce the latest purchases of the year. Thus, units that arrived last are the first ones to be sold. The units ending are the beginning inventory of 3000 units and 500 units of Jan 17 purchase. These results are presented graphically as follows:

Table 2.2.1

Cost of Goods Available for Sale

Units Available
Beginning Inventory	4,000
Jan 17	500
Jan 17	500
Mar 22	3,000
Oct 15	3,000
Total	11,000

4,500 units in ending inventory

6,500 units sold

Following the data presented in Table 1, we can find the cost of goods sold and ending inventory using LIFO method. These findings are presented below:

Table 2.2.2

Cost of Goods Sold

Date of Purchase	Units	Unit Cost	Total Cost
Jan 17	500	$ 6.00	$3,000
Mar 22	3,000	7.00	21,000
Oct 15	3,000	7.50	22,500
Total	6,500		$ 46,500

Table 2.2.3

Cost of Ending Inventory

Date of Purchase	Units	Unit Cost	Total Cost
Beginning Inventory	4,000	$5.50	$22,000
Jan 17	500	6.00	3,000
Total	4,500		$25,000

Table 2.2.4

Summary

Beginning Inventory (4000 units @ $5.50)	$ 22,000
Plus: Purchases (7,000 units from Table 1)	49,500
Cost of Goods Available for Sale (11,000 units from Table 2.2.1)	71,500
Less: Ending Inventory (4,500 units from Table 2.2.3)	(25,000)
Cost of Goods Sold (6,500 units from Table 2.2.2)	$ 46,500

2.3: Comparison

This section provides the comparison between the two inventory methods in the period of rising costs (inflation). Under FIFO, cost of goods sold is lower than that of under LIFO. This happens because of the lower costs of the earliest purchases that are assumed to be sold first. LIFO costs of goods sold include the highest most recent cost of purchases and therefore, LIFO cost of goods sold is higher than FIFO’s. If we look at the ending inventory under both methods, we see that ending inventory under LIFO is smaller than under FIFO. This happens because LIFO ending inventory includes the lower costs of the earliest purchases. This comparison is presented in the table below:

Table 2.3

	FIFO	LIFO
Cost of Goods Sold	$ 38,500	$ 46,500
Ending Inventory	33,000	25,000
Total	$ 71,500	$ 71,500

III. Companies Using FIFO and LIFO

This section presents the approximate number of companies that use LIFO versus those that use FIFO in different time periods.

FIFO inventory method is mostly used by companies and industries that sell nonperishable goods. There is no concern among these companies that the product would spoil or expire anytime soon. Companies that would most likely use FIFO method are electronic stores because of deflation in this industry. Television, radio, personal computer, software and all other electronic devices industries face significant deflation and therefore these companies are good users of FIFO method. Clothing industry is another good user of FIFO method because of lack of inflation in apparel stores. As indicated by Morse and Richardson (1983), during the period from 1954-1978, textile companies initially used LIFO for cotton products but later switched to FIFO while the drug companies used FIFO exclusively over this whole period.

The companies that would mostly use LIFO methods are those companies whose products are perishable i.e. that expires soon such as food industries, supermarkets, pharmaceuticals etc. Other companies that are more likely to use LIFO are those that see high inflation such as electrical supply retailers and wholesalers, who saw huge inflation over the past few years. Farm and ranch supply stores, grocery and food products sellers and all drug stores mostly use LIFO because of rising costs of goods. Morse and Richardson (1983) indicated that oil companies used LIFO during their whole study period, while the steel companies swetiched to LIFO in late 1940s and early 1950s.

LIFO has widely been used as an inventory valuation method for many years by energy producers and mining companies. The following graphs show the widespread use of LIFO among manufacturing companies in 2006 (Graphs 3.1 & 3.2) and 2009 (Graphs 3.3 & 3.4) from the survey done by RSM McGladrey.

Graph 3.1

Graph 3.2

Graph 3.3

Graph 3.4

Table 3.5 shows the results of a survey of inventory methods used by 600 large public companies in 2003 and 1973. As can be seen, FIFO is the most popular methods in both periods, but a dramatic increase is observed from 1973 to 2003, suggesting that firms are increasingly using LIFO. The column total is greater than 600, which shows that firms in the sample use multiple methods.

Table 3.5

	2003		1973
	# of Companies	% of Companies	# of Companies	% of Companies
FIFO	384	46%	394	43%
LIFO	251	30	150	16
Average	167	20	235	25
Other	31	4	148	16
Total	833	100%	927	100%

IV. Switch from FIFO to LIFO or LIFO to FIFO

This section provides the incentives that managers have in choosing the valuation method and provides reasons as to why they prefer one method over the other.

Various researchers have studied the use of LIFO/FIFO method and the effects of switch from one method to another. Even though tax effect is one of the reasons for the switch, various researchers have found more reasons for the switch from one to another such as agency theory, bookkeeping and related costs etc. This section will describe the incentives that play a role in deciding which method to use for valuation purposes.

4.1 Tax Benefits

This is the primary reason for choosing LIFO over FIFO. This is foremost explanation of the LIFO or FIFO choice. As observed earlier in the paper, inventory method influences the net income reported through the costs of goods sold. In periods of inflation, LIFO produces higher cost of goods sold and thus lower net income. This reduces the tax liability faced by the firm. The tax regulation requires that firms using LIFO for tax purposes must also use it for financial reporting. Therefore, “tax effects should be an important factor in explaining the use of LIFO for financial reporting purposes (Morse and Richardson 1983).” The tests conducted by this research shoed that the tax-related variable i.e. average cost of goods sold difference was significant and that tax benefits of using LIFO was the most dominating factor among all variables. This study found no significant tax benefit criteria for firms that changed their valuation method from LIFO to FIFO.

Cushing and LeClere (1992) found that tax considerations explain slightly more of the LIFO/FIFO choice behavior of firms than do other variables of nontax economic consequences of LIFO/FIFO choice. They also did a questionnaire by sending the CFO of the 223 sample firms as to list the number of reasons as to why firms might elect use LIFO rather than FIFO and vice versa. The results of this questionnaire suggested that LIFO’s ability to lower the firm’s tax liability was the most important reason for the use of LIFO.

4.2 Size of Firm

Young and new companies start their business using FIFO method and turn to LIFO method once their business grows. The new companies have incentive to make them look credible in front of investors and creditors by showing their company as profitable. This is done by using FIFO. FIFO reports lower cost of goods sold and thus, higher net income. As the company grows, these firms have incentive to report lower income to reduce their tax liability. Morse and Richardson (1983) provide various reasons that the size of firm maybe related to the choice of LIFO. One such reason is the political costs. The size of firm may proxy for political costs. Large firms may wish to avoid appearing monopolistic which is evident by excessive profits. Therefore, large firms may have incentive to lower financial reported income by choosing an accounting principle valuation method that lowers their reported income and one such choice could be to choose an inventory method that lowers income (Morse and Richardson 1983). The test conducted by Morse and Richardson (1983) also shows that the size of firm variable is significant. Thus, size of firm is closely related to the use of LIFO.

4.3 Agency Theory

This is another explanation for LIFO/FIFO choice. Morse and Richardson (1983) describe the two different agency relationships that might influence this inventory decision. One is the relationship between managers and shareholders and the other is the relationship between shareholders and bondholders. These agency relationships can explain why firms choose one method over the other. Compensation contracts between managers and shareholders are assumed to be tied to the potential earnings. Managers always have incentives to maximize earnings in order to gain maximum personal benefit from the contract. Morse and Richardson (1983) examined “earnings growth using cost of goods sold based on the FIFO method in an attempt to explain the use of LIFO versus FIFO.”

The other agency relationship is that between shareholders and bondholders. Bond covenants are based on accounting numbers which put a constraint on management from making certain decision which are unfavorable to bondholders. The choice of inventory valuation method is most likely influenced by these covenants if one method violates the covenant and the other does not.

4.4 Bookkeeping Costs

These costs also determine what method firms use. There maybe bookkeeping costs associated with the changing and maintaining of LIFO method, which in turn, may influence the decisions of firms in choosing their inventory valuation method. In using LIFO, firms incur a “fixed” cost which gives incentives to large firms to use LIFO. This is because larger firms obtain larger tax benefits that can offset the fixed cost. According to Morse and Richardson (1983), larger firms would more likely have the expertise to make the LIFO calculations. All this suggests that larger firms are more likely to cover their fixed costs that are incurred in using the LIFO method because they get larger tax benefits. For example, if it costs one million dollars to covert to LIFO for any size of firm, then only those firms with LIFO tax benefits greater than one million dollars will change to LIFO because they are able to cover their fixed costs through large tax benefits (Morse and Richardson 1983). These bookkeeping costs also prevent FIFO firms in switching to LIFO because the potential tax benefits are lower than these bookkeeping costs that would incur if small firms switch from FIFO to LIFO (Cushing and LeClere 1992).

4.5 Better Matching of Costs and Revenues under LIFO

LIFO provides a better matching of costs and revenues. The result of the questionnaire done by Cushing and LeClere (1992) indicated that better matching of revenues and costs under LIFO were also considered important by most respondents. Blakley and Knuston( 1963) also presents evidence that LIFO presents better matching of revenues and costs under conditions of changing price levels.

With this being evident in the above studies, it is interesting to see a recent change by Home Depot, Inc. of its inventory valuation method. In 2008, Home Depot changed its inventory valuation method from FIFO to weighted average method. The reason provided by Home Depot management of this change was that it expects that weighted average would provide better matching of costs and revenues.Some of the shareholders of the company perceive it as “earnings management” by managers in manipulating profit margins. Since cost of goods sold affects profit margins, this switch can be perceived as “smoothing” of profit margin.

V. Why Firms would use FIFO?

Other reasons are also presented by prior researchers on why firms would use LIFO instead of FIFO. Several reasons are presented as to why firms would forego million of dollars in potential tax savings by not switching from FIFO to LIFO. Some of these reasons include LIFO layer liquidations, LIFO bookkeeping costs, declining production costs, and contradictory tax and financial reporting rules on accounting for inventory obsolescence, concern about the complexity of LFO and effects on debt covenants (Cushing and LeClere 1992). Firms that have small level of inventory would tend to forego the tax benefits because these tax benefits would be very minimal. However, firms that have high level of inventory would find LIFO detrimental because of unfavorable tax and cash flow effects from unexpected LIFO layer liquidations.

Uncertainty about future is another reason that prevents firms to make this change. Since they are not sure about future consequences of the switch, they tend avoid changing valuation method to LIFO. Also, the switch is not easily reversed, which induces firms to stay with FIFO and not to make this change (Lee and Petruzzi 1989).

VI. Few Examples of Switch

This section presents examples of firms and companies that either switched their inventory valuation method from FIFO to LIFO or from LIFO to FIFO.

Bemis Company, Inc switched from LIFO to FIFO in 1999. Bemis Company, Inc. is a major supplier of flexible packaging used by leading food, consumer products, medical and pharmaceutical companies worldwide. The company had used LIFO since 1960. The reason provided by the management of this change after the long time was that this change from LIFO to FIFO inventory valuation method “benefits the company by providing the best matching of the applicable raw material cost of a unit of product to the product’s selling price.” According to them, FIFO method provided a clearer picture their operations. The change resulted in incremental tax payments of approximately $12 million.

Milacron, Inc changed its inventory valuation method in the fourth quarter of 2004. It changed its valuation method for certain inventories in its North American machinery technologies segment. They previously used LIFO method and were switched to FIFO method, retroactive to the beginning of the year. The reason for the switch from LIFO to FIFO was that FIFO method results in a balance sheet presentation that is more reflective of current costs.

Books A Million, Inc. adopted the LIFO inventory method in 2003. The company changed from FIFO method to LIFO. The reason provided by the management was that LIFO attains a more appropriate matching of costs and expenses. The change was accounted for prospectively.

VII. When to Switch?

The firms also have to decide as to when to make a switch from one method to another. Firms mostly tend to switch when the potential benefits from the switch are maximized. Morse and Richardson (1983) examined potential tax benefits by comparing the benefits of using LIFO in the change year to the tax benefits of using LIFO in other years. A significant tax benefits were observed in the years when the change was made from FIFO to LIFO. Firms make this change in a particular period. Companies do not merely switch from one method to another. They look for maximizing their benefits and change to LIFO when there are increased tax benefits from doing so. Firms would wait until the tax benefits maximize to a certain level before changing to LIFO. It is observed that tax benefits are greater in the year a change is made to LIFO. The following figure depicts the tax benefits of using LIFO during years surrounding the change: