A telecommunications equipment company has used the Last-In, First-Out (LIFO) method adjusted for lower of cost or market for a number of years. Due to falling prices of its equipment, it has had to adjust (reduce) the cost of inventory to market each year for two years. The company is considering changing its method to First-in, First-Out (FIFO) adjusted for lower of cost or market in the future.
If the changes were made, why would management expect fewer adjustments to market in the future?
The Last-In, First-Out (LIFO) method assumes that the units purchased latest are sold first, so only the older units remain in inventory. By contrast, the First-in, First-Out (FIFO) method assumes that the older units are sold first, so only the units purchased latest remain in inventory. In a time of falling prices, the older units in inventory will cost more than those purchased later. The lower of cost or market convention provides that the cost of inventory should be reduced to its "market" value. ("Market value" is the replacement cost of the inventory, but not greater than its net realizable value or lower than its net realizable value minus the normal profit on its sale. Net realizable value is the inventory's expected selling price less the costs to complete it and dispose of it.)
The discussions on consistency and full disclosure are excerpted from The CPA Journal at http://www.nysscpa.org/cpajournal/2006/306/essentials/p44.htm.
SFAS 154, Accounting Changes and Error Corrections, calls for "retrospective application" for voluntary changes in accounting principle. This standard uses the term "restatement" to refer to revision of previously issued financial statements to correct an error. SFAS 154 enhances consistency for the same company across time and improves comparability with companies that use International Accounting Standards.
Retrospective application means that a change in ...
Citing specific accounting pronouncements, this solution examines the meaning of the Last-In, First-Out; and First-In, First-Out flow assumptions, the computation of lower of cost or market, and the consistency, disclosure, and conservatism implications of changing from one method to another. It also discusses the need for future adjustments if the change from LIFO to FIFO (with lower of cost or market) occurs in an environment of falling prices.