Under lifo the oldest costs remain in the inventory

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!Under LIFO, the oldest costs remain in the inventory asset account. These form the ‘bottom layers’. Sales are assumed to be made from the higher layers. !This may result in part of inventory at very old cost values. This could cause two problems: !Inventory may be undervalued as compared to current costs.!If inventory quantities ever go to such a low level that these low costs are matched against revenues (in COGS) income will show such a large increase that has nothing to do with economics. This is called a LIFO liquidation or dipping into the LIFO layers.
19 LIFO Liquidation Example Beginning Balance as of Year 5 consists of 460 units, purchased as followsYearUnitsUnit CostTotal Cost1100505,0002110606,6003120809,600413010013,000Total46034,200Cost of unit during Year 5120Sales during Year 5, units360Sales price200Year 5 Purchases = 0 UnitsYear 5 Purchases = 360 UnitsRevenuesCost of Goods SoldGross ProfitIncome TaxesNet IncomeFirms must disclose the income effects of liquidating LIFO layersReinstatement (i.e., layers remain untouched) (40%) 20 !In situations where the ending inventory decreases from the level established at the close of the preceding year, the enterprise experiences a decrement or LIFO liquidation. Decrements reduce or eliminate previously established LIFO layers. !To determine the effect of the liquidation, management must compute the difference between actual cost of sales and what cost of sales would have been had the inventory been reinstated. CATERPILLAR example: !LIFO Inventory Decrement Benefits– A significant portion of Caterpillar's inventory is valued using the last-in, first-out (LIFO) method. With this method, the cost of inventory is comprised of "layers" at cost levels for years when inventory increases occurred. A LIFO decrement occurs when inventory decreases, depleting layers added in earlier, generally lower cost, years. A LIFO decrement benefit represents the impact on profit of charging cost of goods sold with prior year cost levels rather than current period costs. !Inventory quantities have been further reduced during the three and nine months ended September 30, 2009. This reduction resulted in a liquidation of LIFO inventory layers carried at lower costs prevailing in prior years as compared with current costs. The effect of this reduction of inventory that is not expected to be replaced by the end of 2009 decreased Cost of goods sold in the Consolidated Results of Operations by approximately $120 million and increased Profit by approximately $100 million or $0.16 per share for the three months ended September 30, 2009. For the nine months ended September 30, 2009, LIFO liquidations decreased Cost of goods sold by approximately $230 million and increased Profit by approximately $185 million or $0.30 per share. Additional LIFO liquidations may occur during the fourth quarter of 2009.
21 How to Convert LIFO Accounts to FIFO Income statement: !To convert Cost of Goods Sold (COGS) / Pretax Income: COGSFIFO= COGSLIFO- ΔLIFO Reserve Pretax IncomeFIFO =Pretax IncomeLIFO+ ΔLIFO Reserve !To convert tax expense: Tax ExpenseFIFO

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