Subject 4. The LIFO Method
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
In the U.S., firms that use LIFO must report a LIFO reserve. The LIFO reserve
is the difference between the inventory balance shown on the balance sheet and the amount that would have been reported had the firm used FIFO. That is:
InventoryFIFO = InventoryLIFO + LIFO Reserve
It represents the cumulative effect over time of ending inventory under LIFO vs. FIFO.
When adjusting COGS from LIFO to FIFO: COGSFIFO = COGSLIFO - Change in LIFO Reserve
So far, discussions have been based on the assumptions of rising prices and stable or growing inventory quantity. As a result, the LIFO reserve increases over time. However, LIFO reserves can decline for either of the two reasons listed below. In either case, the COGS will be smaller and the reported income will be higher relative to what they would have been if the LIFO reserve had not declined. However, the implications of a decline in the LIFO reserve on financial analysis vary, depending on the reason for the decline.
- Liquidation of inventories. When a firm reduces its inventory, the old assets flow into income. The COGS figure no longer reflects the current cost of inventory sold. This is called LIFO liquidation. Gross profit margin will be abnormally high and unsustainable ("phantom" gross profits). To defer taxes indefinitely, purchases must always be greater than or equal to sales. A LIFO liquidation may signal that a company is entering an extended period of decline (and needs the "profit" to show as income). Analysts should exclude this profit from recurring earnings, as it is not operating in nature; the reported COGS should be restated by adding back the decline in the LIFO reserve to remove the artificial boost to net income.
- Price declines. The lower-cost current purchases enter reported LIFO COGS when purchase prices fall, reducing the cost differences between LIFO and FIFO ending inventories. As a result, the LIFO reserve declines. Such a decline is not considered a LIFO liquidation. Amounts on the balance sheet are still outdated but those on the income statement are still current. However, the tax benefits are lost under LIFO. For analytical purposes, no adjustment is required for declining prices, since price decreases are a normal business situation.
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