LIFO(Last In First Out) is a commonly used inventory recognition method, mostly in the United States. It will assume that the latest inventory will be sold first from the accounting perspective, not necessarily physically. Since the inventory cost usually varies, in that case, even for the same physical goods and same resale, different ways of recognition the cost might lead to different financial performance on the paper. LIFO is said to have positive impact on the cashflow when inventory’s cost are uptrending because recognizing expensive cost will reduce profit, hence, less tax.
This article will focus on a terminology which is called LIFO reserve. It is defined to be the difference between inventory amount recognized under two different methods LIFO and FIFO. By having LIFO reserve, inventory value and COGS under one method can be converted to another easily.
Now let’s see how to adjust some of the numbers when compare a company reported under LIFO to the ones that aren’t.
The inventory amount under LIFO will need to add the LIFO reserve in order to reach the inventory amount under FIFO
COGS under LIFO should subtract the increase in LIFO reserve to reach COGS under FIFO
Now let’s explain why, we add a number to the end of each variable to represent the year, XXX_1 means year one, so on and so forth. Based on the definition:
LIFO_reserve_1 = inventory_FIFO_1 – inventory_LIFO_1 (Equation1)
LIFO_reserve_2 = inventory_FIFO_2 – inventory_LIFO_2 (Equation2)
inventory_FIFO_2 = inventory_FIFO_1 + Inventory Bought_FIFO – Inventory Sold_FIFO (Equation 3)
inventory_LIFO_2 = inventory_LIFO_1 + Inventory Bought_LIFO – Inventory Sold_LIFO (Equation 4)
Under different methods, inventory bought is the same because it is fixed money paid for new inventory. The wiggle room is that inventory sold can be adjusted depends on which inventory you assume to be sold.
By subtracting Equation 4 from Equation 3, we have
inventory_FIFO_2 – inventory_LIFO_2 = inventory_FIFO_1 -inventory_LIFO_1 – Inventory Sold_FIFO +Inventory Sold_LIFO
Inventory_Sold_LIFO – Inventory_Sold_FIFO = (inventory_FIFO_2 – inventory_LIFO_2) – (inventory_FIFO_1 – inventory_LIFO_1) = LIFO_reserve_2 – LIFO_reserve_1 = increment_LIFO_reserve
In one of the CFA Level1 practice problems, there is a problem which well explained how everything fits together.
The return on assets under LIFO for 2014 is 178/5570 = 3.2%.
Under FIFO, we need to adjust (increase) not only the net income due to the decreasing profit but also increase the asset by adding up the LIFO reserve. Both the numerator and denominator will increase by to different level.
Net_Income_FIFO = Net_Income_LIFO + LIFO_reserve_change adjusted by tax
Total_asset_FIFO = Total_asset_LIFO + LIFO_reserve_2014 adjusted by tax
Net_income_FIFO/Total_asset_FIFO = Net_income_LIFO + (867-547)*(1-t) / [Total_asset_LIFO + 867 * (1-t)] = (178 +(867-547)*(1-33.3%)) / (5570 +(867)*(1-33.3%)) = 6.4%.
The return on asset pretty much doubled under FIFO.
(867-547)*(1-33.3%)) / (867)*(1-33.3%)) = 36% which is pretty high. In that case, by analyzing the LIFO reserve, especially, the change percent in the lifo reserve and how much lifo reserve relative to total asset will give you a good picture of return on assets under different methods.