LOS E and F requires us to:
e. explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
f. convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
a. In the case of rising prices, the use of the LIFO method results in higher COGS and lower profits, thus resulting in lower profits. Lower profits result in a lower outflow of cash in the form of tax payable. Thus, some of the companies resort to the LIFO method of inventory valuation for tax purposes. And if these companies are using the LIFO method for tax purposes they are also, mandatorily, required to use the same method for external reporting also. However, these companies might be using FIFO or AVCO method for internal reporting purposes, as they might be resulting in a better pricing decision.
b. As per the U.S. GAAP, those companies that use the LIFO method must disclose the beginning and the ending balance in the LIFO reserve.
c. LIFO Reserve is the difference between the value of inventory as per the internal inventory reporting method and that as per the LIFO method. The LIFO reserve at the beginning of the reporting period reflects the cumulative difference in the cost of goods sold between the LIFO and internal inventory reporting method. Whereas, the ending LIFO reserve reflects the addition in respect to changes to the LIFO reserve during the year to the beginning balance of reserve.
d. We can write the same in form of an equation as follows:
i. The value of the ending equation as per the LIFO method can be converted into the value as per the FIFO method using the following equation:
EIF = EIL + LREnd …(1)
Where,
EIF = Value of ending inventory as per FIFO
EIL = Value of ending inventory as per LIFO
LREnd = Ending balance in LIFO Reserve
ii. Also, we can write another equation:
COGSL = BIL + P + EIL …(2)
Where,
COGSL = Cost of Goods Sold as Per LIFO
BIL = Beginning Inventory as per LIFO
P = Purchases
EIL = Value of ending inventory as per LIFO
iii. Similarly, for FIFO also:
COGSF = BIF + P – EIF …(3)
Where,
COGSF = Cost of Goods Sold as Per FIFO
BIF = Beginning Inventory as per FIFO
P = Purchases
EIF = Value of ending inventory as per LIFO
iv. Further, we can express the beginning inventory as per FIFO as:
BIF = BIL + LRBeg …(4)
Where,
LRBeg = LIFO reserves at the beginning
v. Also, we can write the value of ending inventory as per FIFO as:
EIF = EIL + LREnd …(5)
Where,
LREnd = LIFO reserves at the end
vi. Incorporating equation (3), (4), & (5), we get the following expanded equation:
COGSF = (BIL + LRBeg) + P – (EIL + LREnd)
We can also write this equation as:
COGSF = (BIL + P – EIL) + (LRBeg – LREnd) …(6)
vii. Combining equation (2) and (6), we get
COGSF = (COGSL) + (LRBeg – LREnd)
Or,
COGSF = (COGSL) – (LREnd – LRBeg) …(7)
Where,
(LREnd – LRBeg) = ΔLR
(Note, ΔLR = Change in LIFO reserves)
viii. Therefore,
COGSF = COGSL – ΔLR
ix. Thus if we are given the value of ending inventories and COGS as per LIFO, and the values of LIFO reserves in the beginning and the end, we can easily find the values of ending inventories and COGS as per FIFO using the above equations.
e. Considering the above equations and the calculation of LIFO reserves, we can deduce the following:
i. In the case of rising prices, the value of COGS as per the LIFO method exceeds the same as per the FIFO method by the value of the change in LIFO reserves. Or,
COGSL – COGSF = ΔLR
ii. Also, the net income as per FIFO exceeds the net income as per LIFO by the after-tax difference in LIFO reserve. Or,
NIF – NIL = ΔLR (1-t)
f. In the above scenario of rising prices, the LIFO reserves will always increase. However, the LIFO reserve would decrease if:
i. the prices are declining, or
ii. in the case of LIFO liquidation.
LIFO liquidation occurs when the amount of sales is significantly higher than the purchases, and the firm has to dig into the beginning inventory to cover for the high amount of sales. LIFO liquidation results in higher profits (usually) because there is a lower cost of the items purchased earlier at a lower price and are sold in the current market. This increase in profits resulting from the LIFO liquidation is called ‘phantom profit’.
Thus, whenever there is an increase in profit despite the rise in the purchase prices, due to running down of inventory, the adjustment should be made to remove any effect of phantom profits.