Guest Author - Consuelo Herrera, CAMS, CFE

An area where forensic accountants should pay special attention is inventory. When claims for losses arise, the accountant needs to know the extent of this loss and the method used to determine the amount. Starting backward to the time where the inventory was stolen is necessary in estimating the inventory at hand at the date of the last physical count.Knowing the cost assumptions is a must to accurately estimate the stock of goods held for sale in the ordinary course of a business or goods that have been used in the production of goods to be sold.

Cost flow assumptions

a) Average cost price items in inventory on the basis of the average cost of all similar goods available during the period.
b) First-In, First-Out (FIFO) assumes that costs are used in the order in which the related goods were purchased. The cost of inventory at hand at the balance sheet date must therefore represent the most current purchase prices.
c) Last-In, Last-Out (LIFO) matches the cost of the last goods purchased against revenue.

The LIFO Reserve

Some companies use LIFO for tax and external reporting purposes, but they maintain a FIFO, average cost, or standard cost system for internal reporting purposes. The difference between the inventory method used for internal reporting purposes and LIFO is often referred to as the LIFO reserve. This is the allowance to reduce inventory to LIFO. The LIFO reserve is a contra-inventory account that must be adjusted to its required balance at the financial statement date.

For example, Co. ABC had inventory of $375,000 using average cost as of 12/31/08 and $320,000 using LIFO. Therefore, the required LIFO reserve at 12/31/08 is $55,000 ($375,000 - $320,000). The unadjusted LIFO reserve balance of Co. ABC was $35,000

To bring the LIFO reserve balance to current, an adjustment of $20,000 must be made. The entry is:

Cost of Goods Sold 20,000
LIFO Reserve 20,000

Either the LIFOR reserve or the replacement cost of the inventory should be disclosed in the financial statements.

Other cost flow assumptions

During periods of rising prices, the LIFO inventory cash flow method reports a higher cost of sales a lower amount for ending inventory than FIFO. Therefore a change from FIFO to LIFO during this period would result in a decrease of net income and a decrease in ending inventory.

As a general rule, dollar-value LIFO uses a double-extension method to compute:
1. The value of the ending inventory in terms of base year prices, and
2. The value of the ending inventory at current prices. The ratio of 2 over 1 provides de specific price index for valuing any layers of inventory added in the period.

This characteristic is unique to this method of inventory. None of the other inventory methods require estimate of price-level changes for specific inventories.

In using LIFO, the cost of the last goods is used in pricing the costs of goods sold. In using FIFO, the cost of the last goods in are used in pricing the ending inventory. Therefore the LIFO method will result in having cost of good sold most closely approximate current cost and the FIFO method will result in having ending inventory most closely approximate current cost.

Practical Example

The Patcon Store presents the following facts pertaining to the cost of one product carried in its merchandise inventory:
Beginnning inventory at hand, 200 units @ $20 = $4,000
Purchase May 19, 600 units @$24 = $14,400
Purchase June 2, 800 units @ $26 = $20,800
Purchase July 20, 400 units @ $30 = $12,000

A physical inventory reveals that 500 units are on hand. If the FIFO method is used with a periodic inventory system, the inventory at the balance sheet should be $14,600 calculated as follows:
400 units of $30 = $12,000
100 units of $26 = $2,600
Ending inventory at FIFO $14,600

With the same information, if the LIFO costing method were used, the cost of good sold of the year amounts to $40,000 calculated as follows:
300 units @ $24 = $7,200
200 units @ $20 = $4,000
Ending inventory at LIFO $11,200

A forensic accountant plays a role a trier-of-fact, mediators, arbitrators. If an issue involves financial matters related to a dispute for an inventory loss, forensic accountants are uniquely suited to act as they can easily spot wrongdoing in inventory management.