LIFO reserve and Conversion between LIFO and FIFO

LIFO reserve = FIFO inventory - LIFO inventory.

In US, if use LIFO, must report LIFO reserve, usually in footnotes

LIFO to FIFO conversion:
Adjusting for LIFO - balance sheet:
· Add the LIFO reserve to LIFO inventories.
· Add (LIFO reserve) x (Tax rate) to deferred tax liability.
· Add (LIFO reserve) x (1 - Tax rate) to retained earnings.

Adjusting for LIFO - income statement:
· Add the change in LIFO reserves to LIFO COGS.
· Add (change in LIFO reserves) x Tax rate to Tax expense.
· Resulting net income will change by (change in LIFO reserves) x (1 - Tax rate).

INVF= LIFO reserve +INVL

COGSF= COGSL – (change in LIFO reserve) =COGSL –(LIFO reserveE – LIFO reserveB)

Where:
GOGSF - cost of good sold under FIFO
GOSSL - cost of good sold under LIFO
LIFO reserve E - the LIFO reserve at the end of the period
LIFO reserveB - the LIFO reserve at the begining of the period

LIFO reserves build up when number of units in the inventory is rising and/or the price is rising. It represents profit not being recognized and tax not being paid

LIFO reserve liquidation occurs when:
· the number of units in the inventory is falling-> the price of inv are no longer recent price and many years out of date->make COGS very low and profit artificially high ->analyst need to adjust the decline in LIFO reserve
· and/or the price is falling.-> FIFO still provided good estimate for inventory and LIFO still is a good estimate for COGS->analyst no need to adjust LIFO reserve

FIFO to LIFO conversion:
As LIFO is not a true reflection of econ value of inventory, FIFO inventory is no desire to convert. But it is useful to convert COGSF to COGSL:

COGSL= COGSF + BIF x Inflation rate

Where: inflation rate can be determined by 1) industry statistics 2) increase in LIFO for another company that the company's begnning inventory (BI) converted to FIFO

COGSL= COGSW +1/2 (BIW x Inflation rate)
Where: BIW - the begining inventory under average cost method.

Effect of different methods on financial items

Impact of LIFO (versus FIFO) when prices are rising, inventory is rising or stable*

	LIFO	FIFO
CFO	Higher (more positive) due to lower taxes	Lower
CFI	No impact	No impact
Net cash position	Higher (more positive) due to lower taxes	Lower
Inventory/Working capital (current asset – current liability)	Higher (more positive) due to lower taxes	Higher
Assets	Lower Due to lower inventory	Higher
Liabilities	No impact	No impact
Equity	Lower Due to lower income	Higher
COGS	Higher	Higher
Taxes	Lower Due to lower EBT	Higher
Net Income	Lower as higher COGS outweigh lower tax	Higher
Profitability (ROE, ROA)	Lower -Lower NI outweighs lower equity	Higher
Leverage (Debt/Equity)	Lower Due to lower inventory	Higher
Inventory turnover	Higher as higher COGS and lower inventory	Lower

Average-cost method
Since it's an average, it would be in between LIFO and FIFO.

LIFO Liquidation
Occur when the balance of inventory declines from the beginning to the end of the period and allow low-cost LIFO inventory layers to flow to COGS. Then, COGS is unusually low, profits and taxes are unusually high.

Conservative practice in ratio analysis:
Use LIFO for profitability ratio & cost ratio and FIFO for liquidity ratio, solvency, asset/equity ratio. For activity (inventory turnover – LIFO for COGS / FIFO for inventory)

Inventories Valuation methods

Inventory Cost
· The net invoice price (less discounts) plus any freight and transit insurance plus taxes and tariffs.
· Inventory includes not only inventory on hand but also inventory in transit.

GAAP allows management to use four methods to evaluate inventory:
· Specific identification
· Average Cost method
· First in first out (FIFO)
· Last in first out (LIFO)

Specific identification
· Each unit purchased for resale is identified and accounted for by its invoice.
· Companies that use this method carry a small number of units.

Average Cost method
· All units in the inventory have the same value.
· Companies that use this method carry a large number of units.
· Effect of any price changes spread proportionately between COGS and ending inventory

FIFO
· Inventory acquired first is sold first. Ending inventory is valued close to its current market value but the COGS are based on old prices.

LIFO
· Inventory acquired last is sold first. COGS reflect the current cost of goods, but ending inventory is based on old prices.

Notes:
· In US, LIFO is popular due to its income tax benefits (higher cost of goods sold in an inflationary environment results in lower taxable income and thus lower income taxes. LIFO is prohibited under IRFS.