LIFO reserve

Adjust the financial statements of LIFO firms to compare with FIFO firms: 

  • LIFO inventory < FIFO inventory 
  • LIFO net income < FIFO net income 
  • LIFO tax < FIFO tax

LIFO reserve (12) 

  • Amount by which LIFO inventory is less than FIFO inventory when price increase
  • Make financial statement prepared under LIFO comparable to those of FIFO firms
    • Add LIFO reserve to LIFO inventory in BS
    • Increase retained earnings by LIFO reserve 
    • Tax:  
      • Cash:= – tax rate * LIFO reserve 
      • Retained earnings:= + (1-tax rate) * LIFO reserve
    • Cash under LIFO and FIFO are the same
  • Convert LIFO’s COGS to FIFO COGS 
    • Note that purchase in the two LIFO and FIFO are the same
  • Effects on Ratios 
    • Profitability 
      • LIFO produce higher COGS → lower earnings
    • Liquidity
      • LIFO results in lower inventory → Lower asset → lower current ratio → lower liquidity
      • Current ratio: ability of the firm to pay short term debt 
  • Activity
    • Inventory turnover (COGS/average inventory)
      • LIFO is higher
      • Adjust from LIFO to FIFO → higher days of inventory on hand 
  • Solvency 
    • LIFO → lower inventory → lower total asset → lower stockholders’ equity → higher debt ratio and debt-to-equity ratio