Now we come to one of the most important aspects of this reading which is to
understand the LIFO method and how to convert LIFO numbers into FIFO
numbers. As I mentioned before, LIFO is permitted under US GAAP and it is not
permitted under IFRS. There is a rule called the LIFO Conformity rule which
is very important, and this rule says that the same method must be used for
tax reporting and financial reporting, in other words, if you are using LIFO for
your financial reporting then that same method is used for tax reporting. This is
different from depreciation. With depreciation you are allowed to use
straight-line method or whatever method is appropriate for financial reporting
and a different method for tax reporting. Okay now, in this particular case if a
company wants to reduce its taxes it can use the LIFO method in the United States
because that's where it is allowed, LIFO method reduces earnings before tax and
then reduces taxes. I mentioned this before also however, companies which use
the LIFO method must also disclose something called the LIFO reserve. LIFO
reserve is the difference between inventory reported at FIFO versus
inventory if it were reported using the LIFO method. This particular Section
has two sub sections; section 1, wIll get into the details of LIFO
reserve and then section 2 will deal with life or liquidations. here is the
formal definition of the LIFO reserve, it is the difference between the reported
life for inventory carrying amount and the inventory amount that would have
been reported if the FIFO method had been used. US GAAP requires that if you
do use LIFO numbers then in the footnotes you disclose the LIFO reserve
so that financial analysts can easily convert from LIFO numbers to FIFO numbers.
This LIFO reserve is extremely important in several adjustment related
calculations that you will need to make. You look at the balance sheet of a
company that is using the LIFO method, the inventory numbers shown on the
balance sheet is the inventory number that is calculated based on LIFO. So, how
do you convert that into FIFO inventory or inventory that would have been
reported if the company had used FIFO? Just looking at this definition, all you
need to do is add the LIFO reserve number so if the reported number is a
150 and in the footnotes you see that the LIFO reserve is 25 then
you simply say that the FIFO inventory is 175. Then you go to the income
statement and you want to convert the reported COGS number from LIFO to FIFO.
If the reported COGS number, let's say, is 100 since the company is using LIFO the
reported number is based on LIFO, how do you convert this to FIFO? What you do is
the following, you take the LIFO COGS as your
starting point and then you subtract the change in LIFO reserve, change in LIFO
reserve is the ending LIFO reserved minus the beginning LIFO reserve. If your LIFO
reserve at the end of the period is 25, and the LIFO reserve at the beginning
of the period is 20, then what is the change in LIFO reserve? That change is
5 and you will have FIFO COGS of 95, so fairly straightforward. Next point,
obviously you might also want to look at the impact on net income. If you are
comparing the net income of two companies or you are comparing ratios
such as net profit margin and so on where net income is required then you
need to make a net income conversion.
FIFO net income is equal to LIFO net income plus the change in LIFO
reserve into (1 minus the tax rate), so you need to remember this relationship.
And then the FIFO retained earnings is equal to LIFO retained earnings
plus LIFO reserve into (1 - T). There are several relationships here and
I'll suggest a method for remembering all these relationships. This one is easy,
why, because this is simply the definition. Also note that there are two
relationships here which are balance sheet based and there are two relationships
which are income statement based. The top one is a balance sheet relationship and
the bottom one is a balance sheet relationship. The balance sheet reports
cumulative numbers in the sense that you are looking at your total inventory at a
given point in time or your total accumulated retained earnings. With
balance sheet related calculations, we use the ending value of the LIFO Reserve
and then obviously with retained earnings there's going to be a tax, in
fact, so you do (1 - T). The middle two expressions here are related to the
income statement. Whenever you are dealing with the income statement, there
you consider the change in LIFO reserve, so notice that there is a change
in LIFO reserve so this will help you remember where to use the LIFO
reserve versus where to use the change, that's point number one. Point number two
is where do you plus and where do you minus because it is easy to imagine questions
which are testing you as to whether you know whether to plus or minus. Okay,
hopefully you recognize the fact that in an environment of rising prices which is
the typical environment, FIFO inventory is going to be more than
LIFO inventory, so that's why you have a plus sign .You also recognize
that in the typical environment where prices are rising, FIFO COGS will be
lower than LIFO COGS, so that explains the minus sign. FIFIO net
income is going to be higher so that explains the plus, if net income is
higher, then retained earnings will also be higher so that explains the plus and
then the third point, how do you remember this (1-T)? Obviously, if your
income is going to be higher, there is also going to be a higher tax so the
impact of tax needs to be taken out and that's where the 1 - T comes into
play...
Before I come to the definition of LIFO Liquidations, I'll just give you
some high-level points. In periods of rising inventory the carrying amount of
inventory under FIFO will exceed the carrying amount of inventory under LIFO.
I'll give you a very straightforward example to illustrate this point, let's
say that you are buying inventory and you first buy at $1 a piece then you are
buying a $2 of piece then you are buying at $3 a piece, so this is time. In periods
of rising inventory which means that your inventory balances are increasing
and let's say that you are using the FIFO method. If you are using the FIFO
method then you are selling the low-cost inventory, your inventory balances are
rising which means that inventories that are valued higher those balances are
rising so the difference between FIFO and LIFO keeps increasing and the
difference between FIFO and LIFO is the LIFO reserve so that is the
straightforward point being made over here. So these are two sub points that
you need to remember, the LIFO reserve may increase for two reasons; increasing
difference between older costs used to value inventory under LIFO and more
recent costs used to value inventory under FIFO so that's illustrated by this
simple example. Also the number of units manufactured or purchased exceeds the
number of units sold so these two things are happening then you have an increase
in LIFO reserve. LIFO liquidation refers to the opposite scenario. If you
have a situation where the number of units sold exceeds units purchased or
manufactured then you have LIFO liquidation. Now coming back to this
scenario, a company is using LIFO and the units being sold exceeds the units being
purchased or manufactured that means that a company then is dipping into
these older layers and a company might be selling over here, but now the COGS is
indicating that you are selling inventory that is only worth $1, so
this is called LIFO liquidation where you are dipping into old cost or
low cost inventory. What will that do to your COGS? It will make the COGS appear
low relative to current prices and what will that do to gross profit it will
make the gross profit look high, but will this high gross profit be a good
indication of what you can expect in the future?
No, because in the future obviously you'd be buying at current prices, so as an
analyst, if you observe a decrease in the LIFO reserve then that is a warning sign
that the current profits are higher than what you can expect in the future. This
can also be used by management to manipulate earnings. If management wants
to show higher earnings then potentially they can do things that allow them to
dip into old inventory so you as an analyst need to be careful whenever you
see LIFO reserves decreasing. Alright now, here is a quick check of whether you
are understanding what's going on. I want you to think about this. Come up with an
answer before I give you the answer. The correct answer is company A, and how do
we know this? First of all when you have LIFO versus FIFO and you are
talking about an income statement item, immediately you know that it's going to
be LIFO and not FIFO, then you also need to consider what's happening to the
LIFO reserve. A decrease and LIFO reserve means that there is
LIFO liquidation taking place and COGS is reflecting old prices because we
are dipping into older layers so that would mean that between A and C, company a
is the better answer, so fairly important. You might see questions like this at the
end of the reading.