In the last post, we covered the LIFO and FIFO methods of inventory management. In this post, we move on to cover LIFO reserve and LIFO liquidation.
As already learned in the previous post, in an inflationary environment ending inventory under LIFO will be lower than under FIFO and COGS will be higher under LIFO than under FIFO. Differences between LIFO and FIFO make a comparison between firms difficult. Therefore, to make a comparison between LIFO and FIFO firms possible, adjustments need to be made to the financial statements of LIFO firms.
Firm’s that report under LIFO also have to report a LIFO reserve. LIFO reserve is the amount by which LIFO inventory is less than FIFO inventory. To make financial statements prepared under LIFO and comparable to those under FIFO we must;
- Add the LIFO reserve to the LIFO inventory on the balance sheet
- Increase the retained earnings component of shareholder’s equity by the LIFO reserve
These adjustments will increase the assets and liabilities by the LIFO reserve and balance the balance sheet. Now let us expand this concept and understand its workings in detail.
As already discussed in the last post, in a rising price scenario a LIFO company pays fewer taxes than a FIFO company, as the COGS of a LIFO company is higher (and net income is lower) than that of a FIFO company. (see the layout of the income statement in this post). Therefore to make a LIFO company comparable to a FIFO company, we will reduce the cash balance of the LIFO company by the tax rate times the LIFO reserve i.e. we will deduct additional taxes to make it comparable to a FIFO company. We will increase the retained earnings by LIFO reserve × (1-tax rate) (as the retained earnings are lower under LIFO than FIFO we have to adjust it upwards by the LIFO reserve to make it comparable with FIFO).
For example, consider a LIFO reserve of $100 and a tax rate of 50%. We will increase the ending inventory on the balance sheet by $100 and reduce the cash balance by $100*50% = 50$. So we net increase assets by $50. On the liabilities side, we will increase the retained earnings component of shareholder’s equity by $100 *(1-0.50) = $50. So we have increased both the assets and liabilities side of the LIFO firm by $50. By making these adjustments, we have made the LIFO firm’s financial statements comparable to a FIFO firm, and the balance sheet is balanced.
Now it is also necessary to make the COGS of a LIFO and FIFO company comparable. The difference between LIFO COGS and FIFO COGS is the change in the LIFO reserve for the period. To convert LIFO COGS to FIFO COGS, we will use the following formula;
FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve)
Let’s understand this intuitively. FIFO COGS is lower than LIFO COGS in a rising price scenario. Therefore subtracting the change in the LIFO reserve from LIFO COGS makes sense. In a falling price scenario, FIFO COGS will be higher than LIFO COGS. Therefore, subtracting a negative change in LIFO reserve (in a falling price scenario the change in the LIFO reserve will be negative) from LIFO COGS makes sense as it will lead to a higher FIFO COGS.
Effect of differences of LIFO and FIFO on Ratios
In a rising price scenario, LIFO COGS is higher than FIFO COGS. Therefore profitability ratios involving COGS will be higher under FIFO than LIFO. For example, gross profit ratio, operating profit ratio, and net profit ratio.
See this post on profitability ratios
In a rising price scenario, LIFO inventory is lower than FIFO inventory. Therefore all liquidity ratios involving inventory such as current ratio will be lower under LIFO than FIFO.
See this post on liquidity ratios
Activity ratios such as inventory turnover ratio (COGS/average inventory) will be higher under LIFO than under FIFO.
See this post on activity ratios
Assets (due to higher inventory) and shareholder’s equity are higher under FIFO than LIFO. Therefore the debt ratio and debt to equity ratio are lower under FIFO than LIFO.
See this post on solvency ratios
LIFO liquidation occurs when inventory balances are not increasing, but the existing inventory is being used up. When the existing inventory gets used up COGS includes older lower costs. So COGS turns out to be lower than it would be when inventories are increasing. Lower COGS leads to higher gross income, operating income and net income and therefore higher taxes.
Management can use LIFO liquidation to inflate earnings artificially. However, this is not sustainable. It is not possible to always use existing inventory without having to replenish it. LIFO liquidation can also occur due to events out of management’s control such as strikes and material shortages.
LIFO liquidation leads to increase in operating cash flow as cash expenses (purchase of inventory) decline. However, increase in tax outflow offsets such declines in cash expenses.
That’s all in this post guys….with this we come to an end of the topic on inventories… if you liked the article don’t forget to share it…. In the next post, we move on to Long-lived assets…stay tuned…
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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