Hello, I'm professor Brian Bushee. Welcome back. In this video, we're going to take a look at the disclosure of a firm that uses the LIFO inventory method. One of the things that you might have to do at some point is compare a LIFO firm to a FIFO firm. To get a reasonable comparison, you're going to have to convert the LIFO firm to a FIFO basis because the ending inventory and the cogs are just so different under the two methods. So this video will show you how to convert a LIFO firm to a FIFO firm. Let's get started. To facilitate the comparison of LIFO and FIFO firms, LIFO firms have to disclose what their inventory cost would be under FIFO. That way, we can convert all the results of the LIFO firm to a FIFO basis. And that's the only direction we go. We can't convert a FIFO firm to a LIFO firm because if you think about it, it would be a pretty daunting task because a company that's always done FIFO would have to go back and look at its entire history of inventory purchases to redo it under LIFO. But if you're doing it under LIFO, it's fairly easy to transfer those results to FIFO. We're going to get a disclosure of something that's called the LIFO reserve. The LIFO reserve is the difference between what the ending inventory would be under FIFO and what it is under LIFO, which is what's shown on the balance sheet. To adjust the income statement, we can use the fact that the change in the LIFO reserve is equal to the LIFO COGS minus the FIFO COGS. And by the way, I'm not going to derive all these equations for you, for you. You can just trust me that the math all works out. So anyway, if we had a LIFO firm, we have their cost of goods sold under LIFO. If we want to convert to FIFO, all we have to do is subtract the change in LIFO reserve and that'll give us what the cost of it sold would be under FIFO. If we want to translate this to net income, we can use the equation that the FIFO net income is equal to the LIFO net income, which is what the LIFO firm's reporting, plus the change in the LIFO reserve times 1 minus the tax rate. We take it times 1 minus the tax rate to get an after tax number, which is what we need to go between the two net incomes. And then finally, one thing that we often want to look at are what are the tax savings a company's getting by using LIFO. The tax savings for the current year are simply the change in the LIFO reserve times the tax rate. And the tax savings the firm has gotten over its entire history would be the value of the LIFO reserve times the tax rate. >> Sorry, I zoned out for a second or two. What is that triangle thing? And when would we ever have to do this again? >> Yeah, I think I zoned out also while reading all those formulas on the slide. A page of formulas is never fun and if I had to spend even more time to explain the intuition, it would have made it even less fun. But the answer to your specific question, the little triangle thing is the Greek letter Delta, which represents a change. And the reason that we need to convert a LIFO firm to a FIFO firm is that the effect of LIFO on the balance sheet and income statement is so distorting that you can't get a meaningful comparison across firms unless you move them to the same inventory method. So what we'll do in this example is show you how to turn a LIFO firm into a FIFO firm. Now, let's take a look at an example of a LIFO disclosure. We're going to look at KP Incorporated, which manufacturers flux capacitors. And if you don't know what those are, you should maybe pause right now and search it on Wikipedia. Anyway, KP uses the LIFO method. So if we want to compare KP's results to a company that uses FIFO, we have to switch KP from a LIFO to a FIFO basis. COGS that it sold for KP are 1,855 during the year 2012 and their tax rate is 35%. The questions we're going to try to answer from the disclosure are, what's the FIFO value of the inventory, which would allow us to adjust the balance sheet to a FIFO basis? What were the FIFO costs to goods sold in 2012, which would allow us to adjust the income statement to a FIFO basis, and then how much did KP save in taxes during 2012? So here's the disclosure in the footnotes. First, let me point out that you often see in the footnotes the breakdown into raw materials, work in process and finished goods inventory that we've talked about in earlier videos. We want to find out now is what would be the FIFO value of the inventory? So remember, the FIFO value of the inventory is whatever the LIFO value of the inventory is plus the LIFO reserve. So if you see at the bottom of the disclosure, we have the value of the LIFO inventory as 518 in 2012. That's what shows up on the balance sheet. The LIFO reserve is 102. Ignore the brackets. That just indicates that it's a credit whereas the inventory numbers are debits. But don't worry, we're not going to do journal entries. So if we take 518 plus 102, you end up with 620 as the FIFO value of the inventory in 2012. Similarly to 2011, you would take the 540, which is the LIFO value on the balance sheet, add the LIFO reserve of 63 to get 603 as the FIFO value. So notice you actually get the FIFO value of inventory disclosed here in the footnote. They just haven't labelled it as such. [NOISE] Next, we're going to try to figure out what cost of goods sold would have been under FIFO during 2012. So our equation is that FIFO cost of goods sold is equal to the LIFO cost that get sold minus the change in the LIFO reserve. So earlier I gave you that the LIFO cost that gets sold was 1,855. The change in the LIFO reserve is the difference between 102 and 63. Again, ignore the brackets. These are both positive numbers, so we're just taking the change in these two positive numbers. And then what we find out is that the FIFO cost to goods sold would be 1,816. So the FIFO cost to goods sold is 39 less than the LIFO cost to goods sold and that 39 is the change in LIFO reserve. >> Shall I infer from this example that COGS under LIFO is always greater than COGS under FIFO? >> No, no, no. Please don't infer that from this example. The reason that LIFO COGS are greater than FIFO COGS in this example is that prices have been rising. If inventory prices have been dropping over time, then FIFO COGS will actually be greater than LIFO COGS. And this has happened in the high tech industries where the prices of say, computer components have been dropping over time. So the FIFO method actually gives you higher COGS than the LIFO method because prices are dropping. The last question we want to answer is how much did KP save in taxes in 2012 by using LIFO. The formula that we saw before is that tax savings equal the change in LIFO reserve times 35. The change in LIFO reserve is the 102 minus 63, which is the $39 difference in cost of goods sold that we saw before. If we take that higher COGS of 39 times 35%, we end up with tax savings of 13.65. Now it doesn't indicate it in here, but those numbers are in millions, so that's actually tax savings of 13,650,000 for KP during 2012. >> Those are some nice tax savings! Why does the U.S. government allow companies to use LIFO? It is like letting them cheat on taxes! Yes, those are some really nice tax savings. Why does the U.S. government allow it? Well, it's probably because the companies that get those tax savings take some of those tax savings and donate them to senators and congressmen, who in turn vote to keep LIFO on the books. And not only that. Sorry. That was probably a little bit too conspiratorial, so ignore that comment. But there is an active discussion right now about whether the U.S. government should get rid of LIFO. In fact, there's a proposal to eliminate LIFO as a way to raise additional taxes without it having to look like you're raising taxes. So could be that in the near future the U.S. government gets rid of LIFO also like the rest of the world has done and that there are no longer these big tax savings available to U.S. companies using LIFO. So now that I just mentioned that the U.S. government may get rid of LIFO so that no one in the world is using it, I should probably cut my losses and stop talking about it. Anyway, that wraps up our look at inventory and I will see you next week. >> See you next video.
