Management Memorandum
The main purpose of this memo is to clarify on some issues based on the LIFO inventory management of stock. Over the recent past, it has been noted with a lot of concern that the cost of managing the stock has been tremendously increasing. As a result, some of the existing policies have been modified to rectify the situation while other new policies have been put in place to enable a smooth flow of inventories with no major cost challenges. Increasing stock costs has resulted into the firm incurring increasing losses due to increased costs.
After a comparative study of the stock management practices, it was noted that the inventory practices of the company adversely affected the company’s returns. Therefore, to that effect, it can be concluded that there is an urgent need to revise some of the inventory management practices. A revision would enable the firm to correct the continuously detoriarating situation.
Executive Summary
LIFO is an acronym which stands for Last-In-First-Out. LIFO is a stock management practice which the management has been using over the years. It simply implies that the last items, most recently, to be purchased are usually the first ones to be sold. In other words, the costs incurred for the most recent items purchased are the first costs to be related to the most current sales on the income statement. Therefore, the costs of the older stock will remain in inventory. At the end of the year, if the inventory quantity increases, then the cost of most current added units becomes a new layer.LIFO layer thereby can also be termed as LIFO increment. LIFO layer is thus the excess ending inventory of the current period minus the ending inventory of the previous period. However, there is a difference between a LIFO increment and a LIFO income. The latter is usually as a result of an increase in the LIFO reserve.
On the other hand, a LIFO reserve can be described as the difference between FIFO inventory and LIFO inventory, where FIFO inventory is simply the approximation of replacement cost. Therefore, the resulting figure gives the taxable income amount, which the company has reduced by using the LIFO accounting method instead of the FIFO accounting method. In practice, as prices of goods and services increase, the LIFO reserves are also anticipated to rise.On the other hand, FIFO is an acronym which stands for First-In-First-Out. It implies that the items purchased or acquired first are usually the first items to be sold. Therefore, the FIFO accounting method is simply the contrary of the LIFO accounting method. However, it is always at the discretion of the management to choose any inventory practice it wishes to adopt. Therefore, a company can use any of the stock method depending on the production capacity of the company, demand and supply of the products, and their respective advantages.
Inventories are assets, goods or items, owned by a firm for sale. Inventory management is thus of great importance in ensuring that stocks are properly accounted, and prevent cases of stocks falling below the minimum requirement level. Moreover, when dealing with a manufacturer company; it becomes necessary to have some raw material inventory together with work-in-progress materials. These inventories are important since they ensure smooth running of the firm. On the other hand, it is equally important to maintain some finished good supplies to cater for demand.
On a different perspective, it is sometimes necessary for a firm to keep a large inventory to cater for the fluctuating aspect of demand. For instance, if there are unstable conditions of demand, the firm may opt to maintain an inventory acting as a buffer to cater for the uncertainty in demand changes. On-hand inventory, buffer inventory, can serve a lot of functions in a firm. For example, if a supplier fails to deliver supplies within the stated time, when the supplies are of low quality and hence substandard; in all the above cases the firm may be necessitated to use the on-hand inventory.
Inventories can be classified into three distinct categories: raw materials inventory, work-in-progress inventory, finished goods inventory and MRO inventory.
Raw materials inventory:
Raw materials refer to inventory items which a firm uses in its conversion process to come up with components and finished products. Additionally, raw materials can be items that the company has itself produced or produced by its subsidiaries. However, they can also be items produced externally outside the company and thus purchased to carry out manufacturing processes. On the contrary, the supplier of the raw material may term it as a finished product while the purchaser sees the item as raw material.
Work-in- progress inventory:
Work-in-progress (WIP) also referred to work-in-process, is composed of all items, materials, or assemblies which are currently being produced or awaiting to be processed in the system. Generally, work-in-process involves all the materials from raw materials that have been released from the initial stage up to the end materials exclusive of finished materials.
Finished goods inventory:
Finished good inventory is the completed products of the materials after going manufacturing processes and thus ready for sale. Therefore, these goods have already passed the inspection requirement stage and hence transferred from work-in-progress to finished goods inventory. After this point, the goods can be sold to final user customers, either to retailers, wholesalers or to distribution outlets.
MRO Goods inventory:
MRO is an acronym which stands for maintenance, repair, and operating goods inventory. This type of inventory is used to facilitate the production process and maintain its infrastructure. However, these products are used up in the production process though are not a direct component of the final products.
Methods to simplify LIFO
LIFO Reserve:
The difference in internal and external book reporting is accounted for in the LIFO reserve account. LIFO effect is the change in the LIFO reserve account at the end of an accounting period. Therefore, LIFO liquidation can be referred to inventory value decreases during the accounting period.
LIFO Inventory Pools:
An inventory pool is composed of items of the same quality and nature. Therefore, items of the same nature are accounted for in a group, pool. Accounting for items in pools reduces bookkeeping and ensures the smoothness of LIFO layers from one year to the other.
Dollar-Value LIFO:
This is the most commonly used methods. In practice, constant dollars are used as the base for measurement. Therefore, a new LIFO layer is only established when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices.
However, there are two inventory systems, and they include perpetual and periodic inventory systems. A company can either use one of the inventory systems. A perpetual inventory system usually keeps a continuous record of the inventory amount. In this system, purchases have to be debited to the inventory account. In addition, as sales are made, the costs of units sold are taken from the inventory account. It is also not necessary to close the accounts when using the perpetual inventory system.
On the other hand, the periodic inventory system does not keep continuity or running records of the inventory amount at hand. Additionally, all purchases are accumulated together in a distinct purchase account, and entries were not made at the time of sales. However, a closing entry is necessary, and a physical account is used to project the ending inventory.
Costs incurred in inventory
Procurement of costs, storage and management is coupled with large costs. In addition, costs associated with inventory can be classified into three categories:
Ordering costs:
This is cost attributed with procurement of materials. Ordering cost largely influences were carried the cost and in turn shortage cost. However, the quantity to order is determined by the Economic Order Quantity (EOQ).
Carrying costs:
This type of cost can be classified further into:
Inventory, storage cost and cost of capital
Inventory storage cost simply involves the cost of building, maintenance of house facilities where the inventory is stored. On the other hand, cost of capital is the investment cost, working capital interests, taxes, insurance costs among others.
Shortage costs
On the other hand, shortage costs or replenishment costs are those costs incurred by the firm in replenishing any stock shortage or finished stock.
Liquidation of LIFO layers:
Liquidation of LIFO layers involves a reduction in inventory quantity, which results from removal of the older layers. LIFO liquidation is usually termed as the erosion of LIFO inventory. Erosion of inventory simply means that there is a shortage or unavailability of raw materials or any other inputs that make a company utilize its already existing assets. In practice, LIFO liquidation results to changes in net income and subsequent tax payments. Therefore, it is important to remove the old layers, low costs because it is expected to come up with an income tax payment that could have been evaded by failure to liquidate the old costs.
LIFO liquidation comes about when the quantity inventory declines. Inventory quantity can decline when a firm sells more than it purchased in the current period. LIFO liquidation profit can be calculated as follows:
(Current cost- LIFO layer cost) multiplied by quantity liquidated.
Therefore, LIFO liquidation leads to increase in the gross margin percentage.
LIFO Tax Savings
LIFO tax savings can be calculated as a LR* Tax rate, where in conservatism interest rate is taken to be 0%.
LR is the cumulative difference between LIFO inventory and FIFO inventory.
LR = (LQL* (RC - HCL)
Where L represents a layer
Q is quantity
RC is replacement cost
HC is historical cost per unit.
In eliminating the distortions by LIFO ratios, several adjustments should be taken. To adjust the inventory ratio, LIFO liquidation profits are added to the numerator. Additionally, the denominator must be altered to show FIFO inventory rather than LIFO inventory.
Tax implications
In general, there is a rule regarding LIFO accounting method on tax which must be adhered to the letter. It states that, if a LIFO method is used for income tax purposes, financial statements should also use the same.
LIFO method has an advantage over the FIFO method in terms of tax liability. In the valuation of tax under LIFO method, a lower income figure is provided compared to FIFO method. Therefore, immediate tax liability is lowered.
However, the tax benefit under LIFO can be reversed if LIFO layers are liquidated or if the purchaser's costs in future. In addition, the tax benefits of this method can bring in various managerial behaviors. It happens when a firm depletes its inventories during an accounting year and yet it wants to prevent tax liability, which is attributed to LIFO liquidation.
On the other hand, the management can decide to purchase a large amount of inventory at the end of the year and then bring it forth in the beginning of the year levels.
Advantages of LIFO
LIFO method has various advantages which include:
All materials consumed are systematically priced in an appropriate and a realistic manner. It also stated that, current costs are incurred mainly in order to meet the current production and sales needs. Therefore, recent costs are expected to be charged in relation to current production and sales.
Using the LIFO inventory method, unrealized inventory gains and losses is normally minimized. Additionally, inflationary prices of current purchases are charged for activities in times of rising prices.
Matching:
In the LIFO accounting method, the most current costs are expected to be matched against recent revenues in order to have a clear and a better assessment of current revenues. During periods of inflation, transitory or paper profits are likely to occur. Transitory profits are usually as a result of failure to match current costs in relation to recent revenues. In addition, inventory profits are created when the inventory costs equated to sales are less compared to the inventory replacement cost. Therefore, the cost of goods sold is understated, while the profits are overstated. Therefore it can be concluded that, in using the LIFO accounting method current costs are equated against revenues, and hence inventory profits lowered.
Tax benefits (improved cash flow)
One of the major reasons that have made the LIFO method popular is the tax benefit aspect. Tax benefit advantage occurs under the situation when price levels are increasing while inventory quantities are not decreasing. Therefore, items currently purchased at higher prices are matched to the revenues.
Future Earnings Hedge:
The LIFO accounting method can be associated with various advantages to the firm. In this method, a company’s expected earnings are not affected by decline in future prices. Therefore, any price decline does not significantly affect the earnings of a company. In addition, most of the current inventory is sold first and thus it prevents chances of any high priced inventory prone to decline in prices. On the other hand, under a FIFO accounting method the inventory earnings are prone to price declines, and thus affect the company’s net income.
However, the LIFO accounting method has some disadvantages, which include:
Reduced earnings
When using LIFO method, it is anticipated that the revenues will be reduced. However, depending on the set objectives of management it may not be of any advantage to reduce earnings on the basis of using LIFO method. Therefore, if a firm is more dependent on external financing than accumulation of retained earnings may be a priority goal.
Inventory understated
One of the core disadvantages of LIFO method is the understatement of inventory on the balance sheet. In practice, this amount can be significant over the years hence create a major alteration in the balance sheet .
Involuntary liquidation
When using LIFO method, costs of goods sold is altered if the previous or part of the base LIFO layers are liquidated. In practice, it is matching of the old costs against recent revenues. Therefore, it will have consequences both financially and in tax valuation.
In conclusion, FIFO method is commonly used because of its accuracy in reflecting the replacement costs as well as giving information about current purchase. On the other hand, LIFO method is advantageous in times of inflation since it lowers tax liability; however, the method does not provide an accurate approximation of replacement costs. Additionally, FIFO method has been recommended by the IFRS, thus does not allow the use of LIFO method.
Works Cited
accountingexplanation.com. 2011. Thursday April 2013.
Loren A. Nikolai, John D. Bazley, Jefferson P. Jones. Intermediate Accounting. New York: Cengage Learning, 2000.
Roman Weil, Katherine Schipper, Jennifer Francis. Financial Accounting: An Introduction to Concepts, Methods and Uses. 2010: Cengage Learning, Mason.
