Mastering the LIFO Method: A Comprehensive Guide | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In today’s lesson, we’re diving into the LIFO method, exploring LIFO reserve, LIFO liquidation, and the required presentation and disclosures for inventories.

Quick Recap: Differences between FIFO and LIFO

Before we delve deeper, let’s sum up the differences between FIFO and LIFO:

• In an inflationary environment, the cost of the inventory bought first is lower than that of the items bought last.
• Under FIFO, the goods sold have a lower cost, and the ending inventory has a higher cost. This results in lower cost of goods sold in the income statement and higher inventory value on the balance sheet.
• Under LIFO, the goods sold have a higher cost, and the ending inventory has a lower cost. This results in higher cost of goods sold in the income statement and lower inventory value on the balance sheet.
• The net income and income taxes reported under LIFO are lower than under FIFO, which means that the amount of cash in the balance sheet is higher under LIFO.

Understanding LIFO Reserve

Due to the discrepancies between LIFO and FIFO, companies that report under LIFO must report a LIFO reserve. The LIFO reserve is the amount by which the LIFO inventory is less than the FIFO inventory. This value allows analysts to make financial statements prepared under LIFO comparable to those of FIFO firms.

To adjust LIFO-based financial statements to FIFO-based ones, follow these four steps:

1. Add the LIFO reserve to LIFO inventory on the balance sheet.
2. Remove the surplus cash from the cash balance, which equals the LIFO reserve multiplied by the tax rate.
3. Increase the retained earnings by the LIFO reserve times (1 minus the tax rate).
4. Subtract the change in LIFO reserve for the period from the LIFO cost of goods sold in the income statement.

LIFO Liquidation: A Potential Shortcoming

One shortcoming of the LIFO method is the possibility of LIFO liquidation. In an inflationary environment, the cost of inventory increases over time, and so does the cost of goods sold. However, LIFO can result in a situation where older, lower-cost inventory is left in the account books. LIFO liquidation occurs when a firm depletes its inventory to levels that record lower costs in the cost of goods sold, artificially inflating earnings for the period. This increase in profit margin is not sustainable, as the firm cannot continue to sell existing inventory without replenishment.

Required Presentations and Disclosures for Inventory Items

Let’s wrap up this topic by discussing the required presentations and disclosures for inventory items. These disclosures can be useful for analysts when evaluating a company. The required financial statement disclosures concerning inventory include:

• The cost flow method used – whether it is LIFO, FIFO, specific identification, or weighted average cost method.
• The total carrying amount of inventories and the carrying amount in classifications, such as raw materials, work in progress, and finished goods if appropriate to the firm.
• The carrying amount of inventories carried at fair value, less selling costs.
• The cost of goods sold – the amount of inventories recognized as an expense during the period.
• The amount of write-down of inventories during the period.
• The amount of reversal of any write-down that is recognized in the period. A discussion on the circumstances or events that led to the reversal is also required. As reversal is prohibited under US GAAP, this is only applicable to firms reporting under IFRS.
• The carrying amount of inventories pledged as security for liabilities.

That concludes our comprehensive guide on the LIFO method for CFA Level I FSA. By now, you should understand how to calculate the cost of goods sold, ending inventory, and gross profit under each of the cost flow methods discussed. You should also be able to grasp the effects of each method on a firm’s ratios and convert statements reported under LIFO to FIFO equivalents.