68 Lesson 2: The LIFO Method and Inventory Method Changes

What does the LIFO reserve (LR) represent in inventory accounting?

The LIFO reserve (LR) represents the difference between inventory value under LIFO and FIFO.

EI_FIFO=EI_LIFO+LR_ENDING

What does U.S. GAAP require for LR

U.S. GAAP requires disclosure of beginning and ending balances for the LIFO reserve (LR) in financial statement footnotes.

What formula can be used to calculate Cost of Goods Sold (COGS) under FIFO when converting from LIFO?

COGS under FIFO can be calculated using the formula: COGS_FIFO = COGS_LIFO - (LR_Ending-LR_Begining).

In rising prices, which inventory method yields higher gross profits and net income before taxes, FIFO or LIFO?

In rising prices, FIFO yields higher gross profits and net income before taxes than LIFO by an amount equal to the change in LR.

How does the treatment of LIFO reserve differ when converting from LIFO to FIFO?

When converting from LIFO to FIFO, the entire LIFO reserve is not added to retained earnings. It is divided between retained earnings (increase in equity) and deferred taxes (increase in deferred tax liabilities).

In rising prices, how does converting from LIFO to FIFO affect equity, liabilities, current assets and net income?

• Equity (retained earnings) increases by: LIFO reserve × (1 - Tax rate).

• Liabilities (deferred taxes) increase by: LIFO reserve × Tax rate.

• Current assets (inventory) increase by: LIFO reserve.

• Net income increased by: LIFO net income + Increase in LIFO reserve × (1 – Tax rate)

What are the LIFO conformity rules, and how do they apply to U.S. companies?

The LIFO conformity rules require U.S. companies to use the inventory method used for tax purposes for financial reporting.

What was the U.S. SEC's proposal regarding the adoption of IFRS and its implications for LIFO?

The U.S. SEC proposed full adoption of IFRS by U.S. reporting companies in 2014, which would eliminate the use of LIFO. Restating to FIFO or weighted-average cost method would result in immediate income tax liabilities when these taxes are paid, deferred tax liabilities would decrease, and cash assets would decrease.

What is the formula for calculating the Inventory Turnover Ratio?

Inventory Turnover Ratio = Cost of goods sold ÷ Average inventory.

Why might the Inventory Turnover Ratio be higher under LIFO compared to FIFO?

The Inventory Turnover Ratio can be higher under LIFO due to stable inventory levels and rising inventory costs, resulting in higher COGS and lower inventory carrying amounts.

How do you calculate the Days of Inventory on Hand?

Days of Inventory on Hand = Number of days in the period ÷ Inventory turnover ratio.

Why does LIFO typically have a lower value for Days of Inventory on Hand compared to FIFO?

LIFO typically has a lower value for Days of Inventory on Hand because of the higher Inventory Turnover Ratio under LIFO, which indicates faster inventory turnover.

What is the formula for calculating the Gross Profit Margin?

Gross Profit Margin = Gross profit ÷ Total revenue.

Why might the Gross Profit Margin be lower under LIFO compared to FIFO?

The Gross Profit Margin can be lower under LIFO due to the higher cost of goods sold (COGS) associated with LIFO, which reduces the gross profit.

What should analysts consider when interpreting financial ratios affected by inventory method differences?

Analysts should interpret financial ratios cautiously, considering the influence of the inventory method on financial metrics. They should be aware that LIFO and FIFO can yield different results and may not directly reflect operational efficiency.

What can lead analysts to erroneously conclude that LIFO is more efficient?

Analysts may erroneously conclude that LIFO is more efficient if they only consider the Inventory Turnover Ratio and do not take into account the impact of inventory method differences on COGS and other financial metrics.

How is the Net Profit Margin calculated, and why might it be lower under LIFO compared to FIFO?

The Net Profit Margin is calculated as Net income ÷ Total revenue. It might be lower under LIFO due to higher COGS. The absolute percentage difference is less in the Net Profit Margin compared to Gross Profit Margin due to income taxes on higher income under FIFO.

How is the Return on Assets (ROA) calculated, and why is it lower under LIFO?

ROA is calculated as Net income ÷ Average total assets. It's lower under LIFO because the impact of lower net income (higher COGS) outweighs the impact of lower total assets (lower inventory carrying amounts). The company appears less profitable under LIFO.

How is the Current Ratio calculated, and why might it be lower under LIFO?

The Current Ratio is calculated as Current assets ÷ Current liabilities. It might be lower under LIFO due to the lower inventory carrying amount. The company appears less liquid under LIFO.

How is the Total Liabilities-to-Equity Ratio calculated, and why might it be higher under LIFO?

The Total Liabilities-to-Equity Ratio is calculated as Total liabilities ÷ Total shareholders' equity. It might be higher under LIFO due to lower retained earnings. The company appears more highly leveraged under LIFO.

What should analysts consider when interpreting financial ratios affected by inventory method differences?

Analysts should consider the impact of inventory method differences when interpreting these ratios. LIFO and FIFO can yield different results for profitability, liquidity, and leverage ratios, and these differences should be understood in the context of financial analysis.

Summarize the effects on a company when it changes from LIFO to FIFO

Notice that the company appears less profitable, less liquid, and more highly leveraged under LIFO. However, the value of the company would be higher under LIFO, as the present value of its expected future cash flows would be higher (due to lower taxes in early years). LIFO is used primarily for the tax benefits it provides in an inflationary environment.

What happens to the LIFO reserve in periods of rising prices and stable or increasing inventory quantities?

in periods of rising prices and stable or increasing inventory quantities, the LIFO reserve will increase as the excess of FIFO ending inventory over LIFO ending inventory increases.

What is a "LIFO Liquidation," and what impact does it have on financial statements?

A "LIFO Liquidation" occurs when a LIFO firm sells more units during a period than it purchases, resulting in lower year-end inventory levels compared to the beginning-of-year levels.

This leads to older, cheaper units being allocated to COGS, which understates COGS. While it temporarily overstates net income, it does not reflect recent, current prices. This can result in higher taxes and reduced operating cash flows. To delay taxes on holding gains of old inventory units, a LIFO firm must consistently purchase at least as many units as it sells.

What are some causes of LIFO liquidation, and when does it occur?

LIFO liquidation can result from strikes, recessions, a decline in demand, or production cuts, causing a firm to sell more units than it purchases. It typically occurs when a firm sells lower-cost LIFO inventory.

How does LIFO liquidation impact financial statements, and why is it a concern?

LIFO liquidation results in surprisingly high reported profits due to holding gains on inventory realization. It's a concern because management may intentionally reduce inventory to inflate profits. Analysts should analyze LIFO reserve footnote disclosures to identify LIFO liquidation and, if detected, adjust COGS upward for the decline in LIFO reserve and lower net income.

What factors influence the likelihood of LIFO liquidation?

LIFO liquidations are more likely with firms that break inventory into numerous categories. Broad categories usually offset quantity decreases with increases in others.

How do declining product prices impact the LIFO reserve, and what adjustments are needed in this case?

Falling product prices result in a decline in the LIFO reserve. A negative change in LIFO reserve implies COGS under FIFO (COGS_FIFO) is greater than COGS under LIFO (COGS_LIFO). In such cases, FIFO reflects lower prices in inventory, providing a more accurate inventory value, and no analytical adjustments are needed.

What is the consistency requirement for inventory costing methods in financial reporting under U.S. GAAP and IFRS?

Both U.S. GAAP and IFRS require consistency in the inventory costing method used.

What criteria does IFRS use to determine the acceptability of a change in inventory policy, and how is it applied?

Under IFRS, a change is acceptable if it provides more reliable and relevant financial information. Changes in inventory policy are applied retrospectively, affecting information for all periods presented in financial reports.

What are the policy change requirements for inventory accounting methods under U.S. GAAP, and what conditions require permission from the IRS?

U.S. GAAP requires changes in inventory accounting policies to be explained and shown as superior to the old method. Permission from the IRS may be needed for changes. Changes must be made retrospectively, except when adopting LIFO (applied prospectively).

What should analysts consider when a company changes its inventory valuation method, and why is this important?

Analysts should assess the impact of inventory valuation method changes on financial statements. Companies may justify method switches for reasons other than those stated, and such changes can affect income tax expense or reported profits. Differences in inventory methods should be considered when comparing a company's performance with its industry or competitors.