Referring to CFAI text, reading 17, example 2, pg 13.
(Question 5) Can someone please explain their income taxes calculation. They have (08 increase in LIFO reserve x 08 tax rate) + (07 LIFO reserve x 07 tax rate) = 898.
(Question 6) Can someone please explain how the amount added to retained earnings is (08 LIFO reserve - assumed taxes) = 2,285. Solution says 'this represents the cumulative increase in operating profit due to the decrease in cost of goods sold (LIFO reserve) less assumed taxes". I get why assumed taxes is removed, but why is LIFO reserve there.
Thanks
Unfortunately I do not have my textbook in front of me, but the idea here is that (assuming LIFO reserve is a positive number) COGS will be higher under LIFO because the inventory that is being sold is assumed to be the newest inventory. Under rising prices, this should mean that COGS will be higher under LIFO, meaning net income (NI) will be lower in comparison to FIFO. The implicit conclusion should be that retained earnings (R/E) will also be lower in comparison to FIFO due to lower NI.
When converting to a FIFO R/E from LIFO, we use:
FIFO R/E = LIFO R/E + [LIFO reserve * (1-t)]
What this formula accounts for is the higher gross profit recongized due to a lower COGS. But the increase in R/E is due to NI, not gross profit! The increase in R/E should be after tax effect of a higher gross profit. Thus we need to use the LIFO reserve after tax.
I hope this sort of explains the reasoning. Unfortunately I only have my Corp. Finance text with me.
Sincerely,
TNG (the new guy)