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.
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)
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 cash flow from operating||22||27|
FIFO inventory = LIFO inventory + LIFO reserve = 110 + 15 = 125
FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve) = 550 – (15 – 10) = 545
FIFO NI = LIFO NI + change in LIFO reserve (1 – T) = 25 + 5 – (5 x 0.3) = 28.5
CFOFIFO = CFOLIFO – Impact of Changes on Net Income Taxes Paid = 27 – 1.5 = 25.5
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
Listed below are some tips to remember the equations:
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:
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:
Analysts must make the following adjustments to account for LIFO liquidation:
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?
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.