Question

Geddes Corporation is a medium-sized manufacturing company with two divisions and three subsidiaries, all located in the United States. The Metallic Division manufactures metal castings for the automotive industry, and the Plastic Division produces small plastic items for electrical products and other uses. The three subsidiaries manufacture various products for other industrial users.

Geddes Corporation plans to change from the lower of first-in, first-out (FIFO)-cost-or market method of inventory valuation to the last-in, first-out (LIFO) method of inventory valuation to obtain tax benefits. To make the method acceptable for tax purposes, the change also will be made for its annual financial statements.

Instructions

(a) Describe the establishment of and subsequent pricing procedures for each of the following LIFO inventory methods.

(1) LIFO applied to units of product when the periodic inventory system is

used.

(2) Application of the dollar-value method to LIFO units of product.

(b) Discuss the specific advantages and disadvantages of using the dollar-value LIFO application as compared to specific goods LIFO (unit LIFO). (Ignore income tax considerations.)

(c) Discuss the general advantages and disadvantages claimed for LIFO methods.

Short answer

Dollar value LIFO differs from general LIFO in terms of valuing inventory at base price. The advantage and disadvantages of both methods depend upon the objective and purpose of valuation.

Step-by-step solution

Pricing procedures under LIFO methods

1) Pricing under the periodic system

Under the periodic system, when the LIFO method is used, the ending inventory is valued at the earliest price. This is because LIFO is the process of using the last in inventory first. So the inventories that are left are the earliest inventory introduced into the pool.

So for pricing the ending inventory, the earliest inventory units are taken at that cost price, followed by subsequent inventories. The sum of the value of all earliest inventory would be the value of ending inventory.

The cost of goods sold under the periodic system using LIFO would be the difference between the cost of all available goods for sale and the cost of ending inventory.

2) Pricing under the dollar-value LIFO method

Under the dollar-value LIFO method, the ending inventories for different years are first converted to the base year rate. Then the layer is computed for each year by taking the difference between the two consecutive years ending inventory at the base price.

All the layers are then converted to the current year rate by multiplying the price index.

The sum of all the layers at the current rent year price is the value of the ending inventory.

Advantages and disadvantages of dollar value LIFO

Advantages:-

1) Dollar value LIFO method is more realistic than the specific identification method. Specific identification is unrealistic as it is impractical to match the actual cost with the issued inventory.

2) Dollar value LIFO method reduces the LIFO liquidation problem more successfully than the specific identification method.

3) Dollar value LIFO is a logical and time-saving approach compared to specific identification.

Disadvantages:-

1) Dollar value LIFO method may be time-saving but more complex than the specific identification method.

2) Selecting the pool of inventories under the dollar-value LIFO method is subjective, leading to manipulating the net income.

3) It is an expensive method of recordkeeping, and the clerical cost is borne, unlike the specific identification method.

Advantages and Disadvantages under the LIFO method

Advantages:-

1) One of the major advantages of LIFIO is marching cost against current revenue. As recent units are utilized first, the cost is matched with the revenue at current prices.

2) There is a tax benefit under the LIFO method as COGS would be higher than any other method.

3) LIFO method protects future earnings from a price decline by working as a hedging system.

Disadvantages:-

1) Under the LIFO method, the net income is reported lower than any other method, specifically in the inflationary period.

2) The ending inventory on the balance sheet is undervalued due to the historical cost against the current cost.

3) Cost flow of inventory under LIFO does not approximate the physical flow of goods.

4) Inventory liquidation is the biggest drawback of the LIFO method.