Dollarvalue lifo eliminates the risk of lifo liquidations market

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The history of LIFO illustrates the interplay of taxes and the general ac-ceptance of accounting principles. The study focuses on both the theoretical evolution of LIFO and its acceptance by taxing authorities and accountants.

Historically, LIFO can be viewed as an outgrowth of the base stock method. A company that uses the base stock method defines a certain q uantity of inventory as the normal amount necessary to continue o perations. Since the base stock is considered a permanent investment, any change in its value is ignored. In co ntrast, inventory above dollarvalue lifo eliminates the risk of lifo liquidations market normal quantity is intended for immed iate resale and is thus a transitory investment.

Goods sold are de emed to come from quantities purchased over and above the base stock. The company on dollarvalue lifo eliminates the risk of lifo liquidations market base stock method thus approxi-mately matches the current costs of current purchases against current revenues. It is difficult to pinpoint the earliest appearance of the base stock method in England. In he audited a foundry in England which dollarvalue lifo eliminates the risk of lifo liquidations market been using the base stock method for a long time.

Even though he does not give specific names, there seems to be no reason to doubt his assertion that the base stock method predates the twentieth century. All writers on the subject agree that the base stock method was not a theoretical construct of accountants, but rather, was developed by businessmen in response to economic pressures. Income tax was one of these important economic pressures. English income taxes started in and were discontinued in The taxes were permanently reinstated in Base stock has a natural attraction for taxpayers because it matches current costs to current revenues and suppresses changes in base stock inventory.

The result is a smoother income stream. Why was fluctuating income considered evil? A company with higher reported profits has to dollarvalue lifo eliminates the risk of lifo liquidations market more taxes than a company with lower reported profits.

Since the higher profit does not necessarily correspond to a better cash flow, the company is forced to pay taxes at a time when the cash flow cannot support such high pay-ments. Furthermore, given a graduated tax system or the lack of carryback-carryforward provisions, a company with fluctuating income pays more taxes in the long run than a company with non-fluctuating income.

The fact that people tried to use the base stock method for taxes enshrouded its use in secrecy. Actual legal precedents for the use of the base stock method in England will not, I think, be found principally because the issue has not, so far as I know, ever been clearly litigated, and the evidence of its use on a permissive basis untested by court action would be most difficult to obtain.

Obviously, a company will not publicize its use of an accounting method that has doubtful tax validity and favorable tax conse-quences. The publicity can have only deleterious effects. The avoidance of publicity explains the difficulty of pinpointing the exact beginnings of the base stock method. Inthe question of the base stock method was examined by a Committee appointed by the Ministry of Reconstruction.

This Committee rejected all proposals to extend the applicability of the base stock method. In the absence of a statutory definition of income, the Committee agreed to accept the base stock method only where its use had already been established.

It should be noted that the report of the Committee in was not unanimous. Four of the ten members of the Committee joined in the following reservation: We are of the opinion that the base stock method of eliminating from trading profits the fluctuations in stock values, is preferable to the creation of reserves from profits enhanced by rising markets, and using up such reserves against losses in falling markets, as the more accurate as-certainment, and more equal distribution of actual trading profits, over a longer period than one year, which results from the method, we advocate, stabilizes the business and enables loan, or preference capital, to be obtained on better terms.

Carson10 believes that the majority view was dictated by the necessity of collecting taxes. If everyone adopted the base stock method, revenue collection could become problematic. In the United States the beginning of the use of the base stock method can be established by the examination of published financial statements.

Inthe American Smelting and Refining Company became the first company to adopt the base stock method. An investigation of prevailing inventory practices made in by the National Industrial Conference Board showed that of widely scattered enterprises selected for the study, 4 percent used a base stock method. Dollarvalue lifo eliminates the risk of lifo liquidations market lead does not spoil, National Lead Company was not forced to move out its dollarvalue lifo eliminates the risk of lifo liquidations market materials first.

To avoid multiple handling, the company usually loaded the most recently purchased materials into the manufacturing process. Similarly, the company often shipped the most recently finished goods to customers. Since the manufacturing process of white lead covered a period of five to six months, there always had to be a certain amount of work in process inventory. A depletion of the work in process in-ventory would have caused a six month lag in production of finished goods.

The minimum inventory dollarvalue lifo eliminates the risk of lifo liquidations market thus a permanent invest-ment necessary for the business to continue as a going concern. A study was made by qualified experts to determine the normal quantity of each of the different kinds of inventories raw materials, work in process, and finished goods necessary for continued op-eration. The study took into account other factors, such as the in-ventory in transit and minimum inventories necessary to insure a delay-free flow of goods through the manufacturing process.

The normal quantity was about 80 percent of the total inventories at the National Lead Dollarvalue lifo eliminates the risk of lifo liquidations market. The normal stock inventory was valued at the lowest price of lead since the date of adoption of the plan in This valuation was accomplished in two ways.

Inthe inventory was written down to the lowest value that could reasonably be anticipated. If the market fell below the book value, the inventory would be written down further to market.

Once the base stock is valued, the problem remains of valuing the difference between ending inventory and base stock inventory. If the quantity of ending inventory is greater than base stock, the excess is valued by using any conventional cost method. National Lead Company, for example, used a weighted average for valuing the excess inventory. However, what is the accounting treatment when ending inventory, due to unforeseen shortages or other factors, is less than base stock?

The theory of base stock is that the base stock is never sold. If base stock is depleted, the goods sold are regarded as being borrowed from the base stock. The goods borrowed must be returned to the base stock. Since the goods returned to the base stock will have to be bought at current market price, the current market value of the deficiency is charged to cost of goods sold and subtracted from the inventory.

A problem can arise when current market values are subtracted f rom base stock book values. If the base stock method is maint ained over a long period of time, market value may be much higher t han book value.

Subtracting the current market value of the defic iency from the ending inventory can result in an understated or even a negative inventory.

A different approach can be used to avoid negative inventory v alues. The market value of the inventory sold from base stock is charged to cost of dollarvalue lifo eliminates the risk of lifo liquidations market sold, but the book value is subtracted from the inventory.

The difference between market and book value is treated as either a liabiIity13 or a deferred credit. Did National Lead Company benefit from the use of the base stock method? Since the Internal Revenue Service never allowed the base stock method for income tax calculation, the company had to keep two sets of books.

The company felt the extra work was well worth it. Since the company did not show any profits on the rise in the value of the inventories, it did not have to write down the inventories when prices fell. A comparative statement of the two methods of valuation viz.

When inventory values fell, National Lead was able to continue paying its dividend since it had maintained its liquidity when inventory values rose. Inthe Treasury Department prohibited the base stock method for taxes. Kansas City Structural Steel Company fabricated steel items on special order. It kept an inventory of raw materials on hand to avoid delay in starting work on contracts.

Materials were taken from inventory as needed and were subsequently replenished. The company contended that its income resulted from the performance of its contracts and not from the change in the value of inventories. The materials were only borrowed from the base stock. The Supreme Court, however, rejected this line of reasoning.

Since the base stock is commingled dollarvalue lifo eliminates the risk of lifo liquidations market all other inventories, there is no clear line separating the base stock from the other inventories.

Since the line is arbitrary and can easily be manipulated, income can be distorted. The Court decision disallowing its use for taxes sealed the fate of the base stock method. When the base stock method was disallowed for tax purposes, a search for a suitable alternative began, The acceptance of LIFO by professional groups and by Congress in the Revenue Acts of and represents the final phase of the early development of LIFO.

When the base stock method was disallowed for taxes, motivations for its use had not disappeared since prices were still fluctuating. Using as the base year when prices equalledthe Wholesale Price Index in fell from A survey of companies shows that the average markdown of inventories in that year was over 26 percent.

Most of this fluctuation of income can be traced to the fluctuation in the value of inventory. LIFO was created to smooth income. In ideal situations, the base stock method and LIFO give identical results. The base stock method is, however, difficult to administer from a tax collection viewpoint. Both the quantity23 and value of the base stock are de-pendent upon management judgments and are thus subject to manipulation for tax avoidance. This rule is very easy to administer.

There are no arbitrary divisions and valuations. The ending inventory is the value of the first goods purchased by the business. Since LIFO is identical to the base stock method in ideal conditions and yet is easy to administer, LIFO became the banner of the base stock method advocates when the base stock method was struck down by the Court in the Kansas City Structural Steel Company case. The following are some important excerpts:.

Current costs of crude oil and products should be charged against current sales as long as inventory quantities remain approximately unchanged. In the future, inventory prices should not be reduced to market prices, when lower than the regular inventory value.

Where dollarvalue lifo eliminates the risk of lifo liquidations market market value of the inventory is less than that carried in the Balance Sheet, such condition should be shown in parentheses or as a footnote. The old base stock practice of writing down the opening inventory was included in the recommendation.

The write-down attempts to avoid any later write-downs resulting from the fall in market prices.

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