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IFT Notes for Level I CFA® Program

R25 Inventories

Part 2


 

4.  The LIFO Method

LIFO is permitted under US GAAP, but not under IFRS. Under the LIFO conformity rule, the When prices are increasing, LIFO method will result in higher COGS, lower profit, income tax expense, and net income. Due to lower taxes, the LIFO method will also result in higher after-tax cash flow.

4.1.     LIFO Reserve

The LIFO reserve is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used instead. The equation for LIFO reserve is given by:

LIFO reserve = FIFO inventory value – LIFO inventory value

US GAAP requires companies using the LIFO method to disclose the amount of the LIFO reserve either in the notes to financial statements or in the balance sheet. An analyst can use the disclosure to adjust a company’s COGS and ending inventory from LIFO to FIFO. This makes it easier to compare the company’s performance with other companies that use FIFO.

The following formulas show how to make adjustments for inventory, COGS and net income from LIFO to FIFO:

FIFO inventory = LIFO inventory + LIFO reserve

FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve)

(The adjusted COGS is also impacted by inventory write-downs)

FIFO NI = LIFO NI + change in LIFO reserve (1 – T)

FIFO retained earnings = LIFO retained earnings + LIFO reserve (1 – T)

Example

Ace Inc. uses the LIFO method for reporting inventory.  Excerpts from Ace’s financial statements are given below:

All numbers in millions of USD 2014 2015
Ending inventory balance 100 110
LIFO reserve at the end of the year 10 15
Cost of sales 500 550
Net income 20 25
Net cash flow from operating 22 27
  1. What inventory values would Ace report for 2015 if it had used the FIFO method instead of the LIFO method?

Solution:

FIFO inventory = LIFO inventory + LIFO reserve = 110 + 15 = 125

  1. What amount would Ace’s cost of goods sold for 2015 be if it had used the FIFO method instead of the LIFO method?

Solution:

FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve) = 550 – (15 – 10) = 545

  1. What net income (profit) would Ace report for 2015 if it had used the FIFO method instead of the LIFO method? Assume tax rate 30%.

Solution:

FIFO NI = LIFO NI + change in LIFO reserve (1 – T) = 25 + 5 – (5 x 0.3) = 28.5

  1. By what amount would net cash flow from operating activities change if Ace used the FIFO method instead of the LIFO method?

Solution:

CFOFIFO = CFOLIFO – Impact of Changes on Net Income Taxes Paid = 27 – 1.5 = 25.5

  1. What is the tax savings that Ace has generated in 2015 by using the LIFO method instead of the FIFO method? Assume last year tax rate 40%.

Solution:

Tax saving = change in LIFO reserve x new tax rate + last year LIFO x old tax rate= 5 x 0.3 + 10 x 0.4 = 5.5

Instructor’s Note:

Listed below are some tips to remember the equations:

  • In equations involving the balance sheet, such as FIFO inventory and FIFO retained earnings, use LIFO reserve.
  • In equations involving the income statement, such as FIFO COGS and FIFO NI, use change in LIFO reserve.
  • It can be confusing to figure out whether to add LIFO or subtract reserve. The intuitive way is to think which value is lower: FIFO or LIFO. For instance, inventory value is higher for FIFO as the last purchased units at higher prices are added to the inventory. So LIFO reserve must be added to LIFO inventory to get the FIFO inventory.
  • But FIFO COGS is lower, so a change in reserve must be subtracted from LIFO COGS to get FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve).
  • For FIFO, if COGS is lower, then net income and retained earnings must be higher. So, LIFO reserve/change in reserve must be added to LIFO.

4.2.     LIFO Liquidations

In periods of rising inventory, the carrying amount of inventory under FIFO will exceed the carrying amount of inventory under LIFO. LIFO reserve is equal to the difference between LIFO inventory and FIFO inventory. LIFO reserve may increase for two reasons:

  • The number of inventory units manufactured or purchased exceeds the number of units sold.
  • Increasing difference between the older costs used to value inventory under LIFO and the more recent costs used to value inventory under FIFO.

If a firm is liquidating its inventory or if the prices are declining, the LIFO reserve will decline.

When the number of units sold in a period exceeds the number of units purchased/manufactured, it is called LIFO liquidation. In LIFO liquidation, the costs from older LIFO layers will flow to COGS and it can be used by the management to manipulate earnings and margins. The gross profits increase because the older inventory carrying amounts are used for COGS while sales are at current prices. An increase in gross profit accompanied by a decrease in LIFO reserve must be used as a warning sign. LIFO liquidation occurs for a number of reasons such as labor strikes, to reduce inventory during an economic recession when demand is low, and earnings manipulation.

The consequences of LIFO liquidation are as follows:

  • COGS does not reflect recent costs during periods of rising prices.
  • Overstates net income.
  • Higher taxable income and higher tax payments.
  • Positive cash flow.

Analysts must make the following adjustments to account for LIFO liquidation:

  • Net income must be lowered.
  • COGS must be adjusted to reflect current prices for the replaced units.

Example

Company A uses LIFO and has an increasing LIFO reserve. Company B uses FIFO. Company C uses LIFO and has a decreasing LIFO reserve. Which company’s COGS best reflect current costs?

Solution:

Company A’s COGS best reflects current costs because it uses the LIFO method and has an increasing LIFO reserve. Even though company C uses LIFO, it has a decreasing LIFO reserve, which may be an indicator of LIFO liquidation. In that case, COGS will not reflect current costs. Company B uses FIFO, hence its COGS reflects older costs.


FRA Inventories Part 2