Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 6 Inventories 279

As shown on page 278, the lifo reserve may be quite large for some companies. To

illustrate, the inventory, lifo reserve, and relative size of the lifo reserve for some

well-known companies are listed below.

(In millions) Percent Lifo

Lifo Reported Lifo Fifo Reserve to

Company Inventory Reserve Equivalent Fifo

ChevronTexaco Corporation $ 2,983 $3,036 $ 6,019 50.4%

United States Steel Corporation 1,197 770 1,967 39.1%

Caterpillar Inc. 4,675 2,124 6,799 31.2%

General Motors Corporation 11,717 1,442 13,159 11.0%

Ford Motor Company 10,766 1,001 11,767 8.5%

The Kroger Company 4,356 373 4,729 7.9%

General Electric Company 9,589 661 10,250 6.4%

Tiffany & Co. 1,057 64 1,121 5.7%

The wide differences in the percent of lifo reserve to lifo are a result of two major

factors: (1) price inflation of the inventory and (2) the age of the inventory. Generally,

old lifo inventory combined with rapid price inflation will result in large lifo reserves,

such as those seen in the natural resources industry.

If a business sells some of its old lifo inventory, the lifo reserve is said to be liqui-

dated. Since old lifo inventory is normally at low prices, selling old lifo inventory will

result in a lower cost of merchandise sold and a higher gross profit and net income.

For example, United States Steel Corporationreported the following in a note to its

financial statements.

Cost of revenues was reduced and income (loss) from operations was improved by $16

million and $9 million in 2004 and 2003, respectively,...as a result of liquidations

of LIFO inventories.

Whenever lifo inventory is liquidated, investors and analysts should be careful in

interpreting the income statement. In such cases, most investors and analysts will ad-

just earnings to what they would have been under fifo.

Use of the Average Cost Method

As you might have already reasoned, the average cost method is, in a sense, a com-

promise between fifo and lifo. The effect of price trends is averaged in determining the

cost of merchandise sold and the ending inventory. For a series of purchases, the av-

erage cost will be the same, regardless of the direction of price trends. For example, re-

versing the sequence of unit costs presented in the preceding illustration would not

affect the reported cost of merchandise sold, gross profit, or ending inventory.

VALUATION OF INVENTORY AT

OTHER THAN COST

Merchandise inventory is usually presented in the Current Assets section of the bal-

ance sheet, following receivables. The method of determining the cost of the inventory

(fifo, lifo, or average) should be shown. It is not unusual for large businesses with var-

ied activities to use different costing methods for different segments of their invento-

ries. The details may be disclosed in parentheses on the balance sheet or in a footnote

to the financial statements.

Determine the proper
valuation of inventory at
other than cost, using the
lower-of-cost-or-market and
net realizable value
concepts.

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