A return to the basics

LIFO vs. FIFO: a return to the basics

Scott C. Gibson

Whether a company presents its financial statements using the last in, first out (LIFO) valuation technique or the first in, first out (FIFO) method, lenders should understand them both. This article presents an overview of both systems and explains their inherent advantages and disadvantages.

Since the early 1970s, a trend toward the increased use of the last in, first out (LIFO) method of inventory valuation has been apparent. The question as to why this trend exists is perhaps answered by the managerial responses from businesses, both large and small, to inflation, higher taxes, and the desire to maximize after tax cash flow from operations. In times of increasing prices and costs, illusory inventory profits may result from using an inventory valuation method other than LIFO. These “inventory profits” result in improved reported earnings, but because the inventory profits are taxed, they reduce a company’s net cash flow.

Distinction Between LIFO and FIFO

LIFO. The LIFO method of inventory costing uses both unit-base and cost-base methods of inventory valuation, in which the latest unit acquisition cost is matched with current sales revenue. Therefore, under LIFO, the order of cost outflow recognized is the inverse of the order of cost inflow. The units remaining in ending inventory are costed at the oldest unit costs available; the units in cost of sales are costed at the most recent unit costs available.

Company administrators who have elected to use the LIFO approach generally believe that costs will either remain stable or increase. Companies that commonly use the LIFO valuation approach are those whose costs predominantly increase each year and whose inventory is generally quite large.

It is often desirable for a company to use LIFO for tax purposes to obtain a cash flow advantage (resulting from decreased tax payments) when inventory costs are rising. However, owing to a congressional income tax rule, a company that adopts the LIFO valuation method for income tax purposes also automatically adopts LIFO for financial reporting purposes.

Therefore, accounting for inventory under LIFO includes complexities relating to federal tax regulations. And it may reflect less favorable financial results owing to earnings reductions and negative effects on the balance sheet as a company reports its financial position.

FIFO. The LIFO costing method contrasts with the first in, first out (FIFO) inventory method, which assumes that the cost of items sold in a period reflects the oldest cost in inventory just before sale. As a consequence, remaining inventory valued at FIFO more closely represents current or replacement cost.

As a practical matter, FIFO more closely depicts the physical movement of goods. Companies generally use the oldest items in inventory first so they can continually roll the stock and prevent deterioration or obsolescence. In times of stable prices, FIFO has been widely used and accepted.

However, in an inflationary environment, FIFO results in “inventory profits”–profits that arise merely from holding inventory–and fails to provide the best matching of costs and revenues.

Comparability

The financial statements of a company using the LIFO approach as opposed to FIFO generally reflect:

* Conservative profits, because LIFO buffers the effects of inflation.

* Better matching of current costs with current revenues.

* Lower liquidity, that is, a lower current ratio.

* Lower equity position, that is, a higher debt-to-worth ratio.

The ABC Company. To clarify the primary differences between LIFO and FIFO, consider the hypothetical example of the ABC Company:

* ABC produces gadgets that sell for $1,000 each.

* At start-up, ABC’s cost to produce each gadget was $500.

* During the year, ABC sold 10 gadgets for a total of $10,000 (10 at $1,000 per gadget).

* As ABC replenished its inventory, inflation increased the production cost to $600 per gadget.

* Total cost to ABC to replenish the inventory was $6,000 (10 at $600 per gadget).

ABC uses the FIFO evaluation method, and it is assumed that the cost of each gadget produced will be $500 (oldest cost). Conversely, if ABC were to use the LIFO valuation method, each gadget’s production cost would be $600 (most recent cost). The effect of each valuation method is shown as follows:

LIFO FIFO

Sales $10,000 $10,000

Cost of sales (6,000) (5,000)

Gross profit 4,000 5,000

Operating expenses (1,500) (1,500)

Income before taxes 2,500 3,500

Taxes * (875) (1,225)

Net income 1,625 2,275

* An assumed 35% income tax rate.

The gross profit differential between the LIFO and FIFO approaches is $1,000. The difference can be attributed to the increased cost of sales (10 at $100 per gadget), resulting in illusory inventory profits when FIFO is used to value ending inventory.

As a result of ABC’s replenishing its inventory at the higher cost, the $1000 of “inventory profits” under FIFO would not be available for stockholder distribution. Under LIFO, current costs are matched against sales, and therefore inventory profits are not recorded.

The cash flow effect. If ABC were to use LIFO as opposed to FIFO, the cash flow effect would be as shown:

LIFO FIFO

Cash from gadget sales $10,000 $10,000

Cost of new inventory (6,000) (6,000)

Operating expenses (1,500) (1,500)

Income taxes (875) (1,225)

Net income 1,625 2,275

Owing to reduced taxes under the LIFO method, greater cash flow results. With lower taxes, ABC has increased amounts of cash for operations, which in turn reduces the need to borrow and incur additional financing costs.

For ABC to remain a going concern, ABC’s inventory levels would need to be maintained. Under the LIFO method, inventory is carried on the balance sheet at the original LIFO cost until existing levels of inventory decrease. Inventory increases are added at current cost in the acquisition year.

A LIFO layer. In the second example, ending inventory would be priced at $5,000 (10 gadgets at $500), even though the current cost of the gadgets is $6,000 (10 gadgets at $600). As long as the inventory level remains above 10 gadgets, the first 10 gadgets in the ending inventory would continue to be carried at $500 per gadget. Increases in the ending inventory above 10 gadgets (referred to as a LIFO layer) would be valued using current cost in the year the inventory level increases.

If, in its second year, ABC increased its inventory to 20 gadgets, it would carry the first 10 gadgets at $500 per gadget and the eleventh through twentieth gadgets (current year layer) at the current cost (assume $800 per gadget) of purchases during that year. The first 20 gadgets in future years’ inventories would continue to be carried at those costs (10 at $500 plus 10 at $800 equals $13,000) until the ending inventory of any year fell below 20 gadgets.

LIFO Statement Adjustments

After several operating cycles, the LIFO inventory amount on the balance sheet may become materially understated when compared with the current costs of new inventory. Therefore, it is advantageous to quantify the actual cost of inventory. To make this quantification, the LIFO reserve and LIFO adjustment, or differential, must be identified.

* The LIFO reserve is the difference between the LIFO inventory amount and the inventory amount of the other valuation method, such as FIFO, being used. The amount will generally be disclosed in the financial statements by those companies subject to Securities and Exchange Commission standards and may or may not be disclosed by other companies.

* The LIFO adjustment, or differential, generally refers to the change in the LIFO reserve from the prior-year reserve to the current-year reserve. However, it can also be defined as the difference between net income used in another valuation method, such as FIFO, compared with the LIFO net income figure. For the purposes of this article, it will be used to refer to the change in the LIFO reserve from one year to the next.

To identify inventory amounts properly, the LIFO reserve is added back to the appropriate inventory accounts. The LIFO adjustment is then calculated by the incremental change in the LIFO reserve. A hypothetical example would be as follows:

LIFO reserve (prior year) $20,000

LIFO reserve (current year) $25,000

LIFO adjustment (current year) $5,000

The LIFO adjustment would need to be calculated for all inventories valued according to the LIFO method. It is crucial that the LIFO reserve amount and the annual decrease or increase in the reserve be obtained. These two items may or may not be provided in the financial statements. Therefore, contact with the company may be necessary to obtain these items.

The cost of sales associated with each applicable inventory account would be adjusted downward by the amount of the LIFO adjustment. The following example exhibits an adjusted cost of sales:

Cost of sales $15,000

Less: LIFO adjustment (current year) ($5,000)

Adjusted cost of sales $10,000

It is important to recognize that the reduction to cost of sales is made by the LIFO adjustment, that is, the change in the LIFO reserve from one year to the next and not the LIFO reserve itself.

As a result of the decrease in cost of sales, profits before income taxes will increase $5,000. If no current losses or loss carry-forwards from prior periods are being experienced, the tax provision (usually classified as deferred taxes) should be increased by the amount of taxes that would be due on the additional $5,000 of net profit. The adjusted after-tax net profit figure would then also be used to increase retained earnings by a like amount.

LIFO Advantages and Disadvantages

The LIFO valuation method has certain advantages, namely elimination of inventory profits, reduction of federal income taxes, and improved cash flow. Likewise, it has disadvantages:

* LIFO cost could exceed market value if costs were to decline.

* The LIFO valuation method is complex and costly to apply.

* LIFO distorts crucial ratios, such as the current and debt-to-worth ratios and inventory turnover.

* LIFO is an end-of-year calculation. Therefore, reliability of interim statements is questionable because a company must forecast prices for the remaining accounting year and estimate year-end inventory quantities.

* Balance sheet inventory is costed at noncurrent unit costs.

Conclusion

The LIFO inventory valuation methods can have a dramatic impact on financial reports. Therefore, LIFO must be recognized and the necessary adjustments made to applicable financial reports to achieve valid credit analysis conclusions. FIFO tends to be a complex technique, and therefore it requires a great deal of study and understanding.

Contact Gibson by e-mail at sgibson@syringabankidaho.com

[c] 2002 by RMA; from the article of the same name in the October 1991 issue of The Journal of Commercial Bank Lending, published by Robert Morris Associates. At the time, Gibson was a credit officer at First Security Bank of Idaho, Boise. He is now senior vice president and chief credit officer of Syringa Bank in central Idaho.

COPYRIGHT 2002 The Risk Management Association

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