25.3: Converting LIFO to FIFO

Question 1

Which four relations hold when prices have been rising over the relevant period?

Answer 1

1. LIFO inventory < FIFO inventory
2. LIFO COGS > FIFO COGS
3. LIFO net income < FIFO net income
4. LIFO tax < FIFO tax

Question 2

What is LIFO reserve? Which two components must be adjusted using LIFO reserve on the balance sheet?

Answer 2

LIFO reserve is the amount by which LIFO inventory is less than FIFO inventory under an inflationary environment with rising prices.

LIFO reserve must be added to:

1. LIFO inventory on the B/S
2. Retained earnings component of shareholders’ equity

Question 3

How is a LIFO firm’s cash and retained earnings adjusted when prices are rising in an inflationary environment?

Answer 3

1. Decrease a LIFO firm’s cash by tax rate times LIFO reserve
2. Increase its retained earnings by the LIFO reserve times (1- tax rate).

Question 4

How is LIFO COGS converted to FIFO COGS on the income statement?

Answer 4

FIFO COGS = LIFO COGS - (ending LIFO reserve - beginning LIFO reserve)

Question 5

What does the difference between LIFO COGS and FIFO COGS represent?

Answer 5

The difference between LIFO COGS and FIFO COGS represents the change in LIFO reserve for the period.

Question 6

What is a LIFO liquidation?

Answer 6

A LIFO liquidation occurs when a LIFO firm’s inventory quantities decline. Whenever the number of units that are sold exceeds the number of units that are purchased or manufactured during a period, the number of units in ending inventory will be lower than the number of units in beginning inventory, and a company which uses the LIFO method is said to experience a LIFO liquidation wherein some of the older units held in inventory are assumed to have been sold.

LIFO liquidation results in higher profit margins and higher income taxes

Question 7

Why are the gross profits under LIFO liquidation unsustainable?

Answer 7

If inventory unit costs have been rising and LIFO liquidation occurs, an inventory-related increase in gross profits will be produced. This increase in gross profits will occur because of the lower inventory carrying amounts of the liquidated units. The lower inventory carrying amounts are used for the cost of sales while the sales are reported at current prices. The gross profit on these units is higher than the gross profit that would be recognized using more current costs.