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Subject 2. The LIFO method

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.

LIFO Liquidations

So far the discussions are 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 of 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 need 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 Amounts on balance sheet are still outdated but those on income statement are still current.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.

Practice Question 1

Liz-Beth Company reported ending inventory on December 31, 2011, of $4,000,000 under LIFO. It also reported a LIFO reserve of $700,000 on January 1, 2011, and $1,000,000 on December 31, 2011. Cost of goods sold for 2011 was $12,000,000. If Liz-Beth had used FIFO during 2011, its cost of goods sold for 2011 would have been ______.

A. $13,500,000
B. $12,300,000
C. $11,700,000

Correct Answer: C

The change in cost of goods sold would be $300,000 ($1,000,000 - $700,000). It would increase by $700,000 and decrease by $1,000,000. Therefore, the cost of goods sold under FIFO would be $11,700,000 ($12,000,000 - $300,000).

Practice Question 2

Companies using LIFO are required to disclose the LIFO reserve. The LIFO reserve is ______.

A. the difference between the inventory at LIFO and the inventory at FIFO
B. the amount of inventory held in reserve in case of LIFO liquidation
C. the difference between the cost of goods sold under LIFO inventory and the cost of goods sold under FIFO inventory

Correct Answer: A

The LIFO reserve shown in the footnotes is the dollar amount difference between the inventory at LIFO and the inventory at FIFO. It can be used to restate the LIFO cost of goods sold to FIFO.

Practice Question 3

Which of the following statements would be true in a LIFO liquidation (assuming the company uses the LIFO inventory valuation method and prices are rising)?

A. Unit purchases are less than unit sales.
B. Unrealized holding gains would be created.
C. Gross margin decreases.

Correct Answer: A

In this situation, some beginning inventory is assumed to be sold, and consequently a LIFO layer is liquidated.

Practice Question 4

How should gross profit be adjusted to account for the illusory income effect associated with LIFO liquidation?

A. Add back the before-tax LIFO liquidation amount.
B. Subtract the before-tax LIFO liquidation amount.
C. Subtract the after-tax LIFO liquidation amount.

Correct Answer: B

By subtracting the before-tax LIFO liquidation amount from the gross profit (which is a before-tax amount), the analyst can determine the portion of gross profit that is sustainable.

Practice Question 5

When purchases exceed sales for the current year in a period of falling prices, profits reported under LIFO will be ______

A. lower than profits reported under FIFO.
B. greater than profits reported under FIFO.
C. the same as profits reported under average cost.

Correct Answer: B

When purchases exceed sales, ending inventory will increase for the period. If LIFO is used, the recent prices, which are falling, will be included in cost of goods. Under FIFO, the result is the opposite: the newer, lower prices will be included in ending inventory. Thus, LIFO profits will be greater than FIFO profits.

Practice Question 6

During periods of sustained rising prices, how will the liquidation of early LIFO layers affect a company's cost of goods sold, net income, and income tax liability, respectively?

A. increase, increase, increase
B. decrease, decrease, increase
C. decrease, increase, increase

Correct Answer: C

Assuming rising prices, liquidation of early LIFO layers will result in a charge to cost of goods sold of the older, lower-cost inventory items. Cost of goods sold will decrease, which will result in a higher net income and higher tax liability.

Practice Question 7

Under the ______ method, inventory write-downs are less likely to occur than under other inventory methods (assuming a long-term environment of rising inventory costs).

C. Weighted average

Correct Answer: A

This is because LIFO inventories are valued at order and lower costs, and thus are less likely to be carried at values that are greater than their net realizable values.

Practice Question 8

Select the correct statement(s).

I. LIFO reserves must be disclosed in a firm's annual report.
II. For income statement purposes, the more recent costs are matched against the current revenues under the LIFO assumption.
III. During periods of falling input prices, FIFO would underestimate gross profit.

A. I and II
B. I and III
C. All of them

Correct Answer: C

Practice Question 9

The manager of Liz-Beth Co. is given a 2% bonus based on income before taxes. The net income after taxes is $11,200 if Liz-Beth uses the FIFO method for inventories. The tax rate is 30%. Cost of goods sold would have been $10,000 higher if LIFO is used. How much is the difference in the manager's bonus if LIFO is used instead of FIFO?

A. $200 higher.
B. $200 lower.
C. $140 lower.

Correct Answer: B

If the cost of goods sold is higher if LIFO is used, then the income before taxes would be lower under LIFO, which means that the bonus will be $200 (.02 x $10,000) lower under LIFO.

Practice Question 10

Which of the following actions would be most likely taken by a manager whose compensation is largely tied to earnings for the period?

A. Reduce the amortization period for the write off of goodwill.
B. Liquidate LIFO inventory layers.
C. Delay or postpone the employer contribution to the company pension plan until after year-end.

Correct Answer: B

This action results in a gain, and the current period net income increases (assuming prices are increasing). This would increase the manager's compensation for this period, and have little or no impact on compensation in future periods.

Practice Question 11

Lang Specialty Golf Inc. maintains its inventory using LIFO costing. Data for 2010 is as follows:

Beginning inventory: $900
Beginning LIFO reserve: $600
Ending inventory: $850
Ending LIFO reserve: $650
Reported cost of goods sold: $8,800
Pre-tax LIFO liquidation effect: $200

Which of the following represents the correct LIFO-adjusted inventory turnover?

A. 6.0 times
B. 5.87 times
C. The amount cannot be determined from the information given.

Correct Answer: A

The correct computation is $8,800 COGS + $200 LIFO liquidation/($ 900 Beginning inventory + $600 Beginning LIFO reserve + $850 Ending inventory + $650 Ending LIFO reserve)/2 = $ 9,000/$1,500 = 6.0 times.

Practice Question 12

Which of the following are reasons for a decline in the LIFO reserve?

I. Price increases in the cost of inventory
II. Price decreases in the cost of inventory
III. Liquidation of inventories

A. I and II
B. III only
C. II and III

Correct Answer: C

A decline in the LIFO reserve can occur for two reasons: (1) there is a liquidation of inventories: more sales are made than purchases, and (2) prices are falling during the period.

Practice Question 13

A LIFO liquidation occurs when ______

A. goods in inventory are damaged and have to be liquidated.
B. the prices of the goods in inventory are increasing.
C. more goods are sold during the period than are purchased.

Correct Answer: C

A LIFO liquidation is a decrease in the level of inventory from the beginning of the period to the end of the period. This will occur when there are more units of inventory sold than were purchased.

Practice Question 14

The LIFO reserve may increase due to ______

I. inventory price increases.
II. more inventory units purchased than units sold.

A. I only
B. II only
C. Both I and II

Correct Answer: C

The increased LIFO reserve should be used to adjust reported LIFO inventory and COGS.

Practice Question 15

The LIFO liquidation can result in ______.

I. higher tax payments
II. more cash flow
III. higher profit margin

A. I and III
B. I and II
C. I, II and III

Correct Answer: C

Higher profit margin, higher taxable income and higher tax payments. The reduction in inventory will generate more cash flow.

Practice Question 16

A company uses the LIFO inventory method, but most of the other companies in the same industry use FIFO. Which of the following best describes one of the adjustments that would be made to the company's financial statements to compare it with other companies in the industry? The amount reported for the company's ending inventory should be ______

A. increased by the ending balance in its LIFO reserve.
B. increased by the change in its LIFO reserve for that period.
C. decreased by the ending balance in its LIFO reserve.

Correct Answer: A

LIFO Reserve = FIFO Inventory - LIFO Inventory Adding the ending balance in the LIFO reserve to the LIFO inventory would equal the ending balance for inventory on a FIFO basis.

Practice Question 17

A company using the LIFO inventory method reports a LIFO reserve at year-end of $85,000, which is $20,000 lower than the prior year. If the company had used FIFO instead of LIFO in that year, the company's financial statements would have reported ______.

A. a lower cost of goods sold, but a higher inventory balance.
B. a higher cost of goods sold, but a lower inventory balance.
C. both a higher cost of goods sold and a higher inventory balance.

Correct Answer: C

The negative change in the LIFO reserve would increase the cost of goods sold under FIFO compared to LIFO. FIFO COGS = LIFO COGS - Change in LIFO reserve.

The LIFO reserve has a positive balance so that FIFO inventory would be higher than LIFO inventory. FIFO inventory = LIFO inventory + LIFO reserve.

Practice Question 18

The year-end balances in a company's LIFO reserve are $56.8 million in the company's financial statements for both 2015 and 2016. For 2016, the measure that will most likely be the same regardless of whether the company uses the LIFO or FIFO inventory method is the ______.

A. inventory turnover.
B. gross profit margin.
C. amount of working capital.

Correct Answer: B

The LIFO reserve did not change from 2015 to 2016. Without a change in the LIFO reserve, cost of goods sold would be the same under both methods. Sales are always the same for both; so gross profit margin would be the same in 2016. The FIFO inventory would be higher because the LIFO inventory and LIFO reserve are added to compute FIFO inventory. Because the inventory balances would be different under FIFO, inventory turnover, and net working capital would also be different under FIFO.

Study notes from a previous year's CFA exam:

2. The LIFO method