Thursday, June 18, 2009

Understanding LIFO Reserve

I'm going to continue to post more CFA related topics from Level I. Although the exam is over, there might be people interested in prepping for Dec, or who possibly stumble upon this blog in later years, but it doesn't hurt for me to try to keep sharp.

If you were like me during the CFA exam, even simple concepts can seem confusing under pressure. One such example for me was the idea of LIFO reserve. Particularly, I often found it confusing to remember when I should use LR or the change in LR to answer questions (when the correct answer is one, the CFA will often have the other as an incorrect answer for those of us not paying attention).

After taking a quick review of the tools to understand the concepts relating to LIFO versus FIFO, some CFA questions require you to understand how the accounting differences of each method affect the balance sheet and income statement and state by how much an account is expected to change or what the ending balance should be.

Firstly, LIFO reserve is defined as the difference in the inventory value if it was stated using FIFO versus LIFO or in other words:

LIFO Reserve (LR) = Inv FIFO - Inv LIFO

Note that LR is cumulative over the life of the company, that is to say that LR is a reflection of financial position which would be reflected in the balance sheet (along with inventory as an asset). So when dealing with financial position, use LR as an absolute value to determine the appropriate adjustment to the inventory.

So when would you use the change in LR? The change in LR reflects what has happened in the year to inventory. For example, if in the most recent year, assume that you purchased 200 units of product but only sold 150 units. Assuming that prices are generally increasing, your LR would go up. Conversely, if you had purchased 150 units, but sold 200 (dipping into your inventory) your LR would go down (selling some of the older, cheaper inventory). Therefore, you can determine that the amount that your LR changes would be reflected by the purchases of inventory versus COGS. Also note:


✠ Note that the key word here is "change". Anything that involves a "change" (implying activity in the year) it always has to do with the income statement (ie using the change in AP, AR, Inv, WC etc in the indirect method to determine cash flow from Net Income). Same goes with accounting for the LR. Also note that in this formula, the LIFO term is first.

[Example] Your company makes the following purchases and sales each year (in order):
  1. 2009 - Buy 100 units @ $50
  2. 2009 - Sell 90 units*
  3. 2010 - Buy 150 units @ $55
  4. 2010 - Sell 155 units*
  5. 2011 - Buy 200 units @ $60
  6. 2011 - Sell 190 units*
What is the COGS, Inv and LR for each year under LIFO and FIFO?

* Just a quick note, we don't really care what the price they are sold at is (we are just accounting for COGS, Inv and LR. If we wanted to know revenue we would want price, but it's out-of-scope for now.

Also note that the number of units in inventory under each method *is the same*. The reason for the difference in inventory value is how you account for their worth.

Dec 2009 (steps 1 and 2)
COGS = 90 units x $50 = $4500
Inv = 10 units x $50 = $500

LIFO (same as FIFO)
LR = 0**

**LR is 0 because our inventory is uniform (that is to say we've only paid one price per unit so far so the accounting under LIFO and FIFO is the same).

Dec 2010 (steps 3 and 4)
COGS = (10 units x $50) + (145 units x $55) = $500 + $7975 = $8475
Inv = 5 units x $55 = $275

COGS = (150 units x $55) + (5 units x $50) = $8250 + $250 = $8500
Inv = 5 units x $50 = $250
(Note you are dipping into your inventory here a little bit).

LR = Inv F - Inv R = $275 - $250 = $25***

***Note also that ΔLR = COGS L - COGS F
(Also note that since LR = 0 last year, ΔLR = LR)

Dec 2011 (steps 5 and 6)
COGS = (5 units x $55) + (185 units x $65) = $275 + $11,100 = $11,375
Inv = 15 units x $60 = $900

COGS = (190 units x $60) = $11,400
Inv = (5 units x $50) + (10 units x $60) = $250 + $600 = $850

LR = Inv F - Inv R = $900 - $850 = $50 ✝

✝ Note that LR has gone up by $25 from last year. ΔLR = $25 also note ΔLR = COGS L - COGS F = $11,400 - $11,375 = $25. Two different methods. Same result.

[Aside] One question that I wonder is if it's possible to have a negative LR. This could theoretically happen in the case where prices are falling, it's not unreasonable to expect Inv F to be less than Inv R. What happens then? Mathematically, it's possible, but from a regulatory stand point something looks funny. I'd anticipate that there is probably some accounting rule that doesn't allow negative LR (or requires you to restate under FIFO). I'll have to look into it.


Linda Keith CPA said...

Great explanation and example! I work with lenders on financial statement and tax return analysis and just got a question about LIFO Reserves. The borrowing company's accountant is saying the lender should 'add it to cashflow' in determining debt-paying ability. I disagreed.

I also think there could be negative LIFO Reserves if pricing were falling from the inception of LIFO. But since LIFO is often used for tax advantage, if the inventory method was adopted during dropping prices FIFO would actually give a lower income and defer taxes.

So another question would be, would the company pick FIFO for short-term tax advantage? If not, negative LIFO reserves would be shown. Can't wait to see what answer you come up with.

Joshua Wong said...

That's an interesting point. Also, I agree with you regarding LIFO reserve and cash flow.

LIFO reserve is a statement of financial position (a non-moving target) versus *change* in LIFO reserve which is reflected as a change in working capital (which still isn't classed as cash flow, but at least more related).

I was looking for examples of real companies I would look at in order to determine if there was such a thing as negative LIFO reserve.

I wanted to look for a company which uses LIFO, has very high inflation on it's prices, but also experienced a crash in price recently (in order to get the math to say LIFO reserve is negative). Sound familiar?

When I find the right oil company to look at, hopefully I'll have more intelligent comments.

Joshua Wong said...

New post on Negative LIFO!

Anonymous said...

Interesting blog and helpful insights...but you say in this post that if you purchase more than you sell, your LR goes up; and if you purchase less than you sell, your LR goes down. But this is not necessarily the case. It all depends on the specs of the inventory units and dollar values. Your example actually demonstrates the 2010 you are purchasing less than you sell, and in 2011 you are purchasing more than you sell, but the LR increases over both periods ($25 per period). I may be missing something, but wanted to point this out.