Is it possible that when the price level is rising that LIFO can result in lower CGS than FIFO? The answer is yes. Dreary
Dreary I think from a LI exam point of view: The only situation where they want us to care about LIFO inventory where the COGs is overstated is: a. A falling price scenario b. and Inventory liquidation occurs. a rising price scenario where LIFO COGS < FIFO COGS – not sure how that can happen. Because even for conversion between LIFO to FIFO Cogs: COGS F = COGS L - Delta LIFO Reserve. This would mean eating into the Reserve?
This might be called inventory liquidation. I am thinking of a situation when very old, low-priced items are left in inventory because of the use of LIFO, which then come to the surface when selling intensifies! Am I making sense? Dreary
The situation where COGS would need adjustment is under Falling prices. This is from Schweser Page 135 LIFO Reserve will decline if 1. Inv. Qty is falling 2. Prices are falling A LIFO Liquidation refers to a declining Inv. balance for a company using LIFO. (units available for sale are declining). In this case, prices for goods sold are no longer recent prices, and can be years out of date. This would make COGS appear to be very low, and Gross and Net profits to be artificially high. An analyst must adjust COGS for the decline in the LIFO Reserve that is caused by decline in the Inv. Quantity. This amount is listed in the footnotes of the financial statements. If prices decline, the differences in the value of the inventory and COGS under LIFO and FIFO is opposite: Value of FIFO Inv. < LIFO Inv. COGS LIFO < COGS FIFO LIFO COGS Is a more accurate estimate of current prices, hence a more accurate picture of economic value. Decline of LIFO Reserve does not mean that COS has to be adjusted, if it occurs because of a Price decline. CP
That’s correct, that’s the only situation when LIFI produces lower CGS than FIFO in a rising price environment. Dreary
Dreary, that’s called a “LIFO Liquidation” and is explicitly discussed at LI. In this scenario, assuming rising prices, COGS is actually understated (but still greater than FIFO COGS, unless the entire inventory is depleted in which case they’re equal). In addition, gross profit will be overstated. cpk123, to your point, I can only think of two situations whereby a “falling price scenario” causes COGS to be overstated. 1) If FIFO were being used (i.e. older, more expensive inventory is moving off the balance sheet inventory account through the income statement COGS account, leaving the cheap new inventory on the books that’s actually more representative of current replacement costs), or 2) prices are falling, LIFO is being used, AND a LIFO Liquidation occurs too. If sales and new inventory are keeping pace, then only the new cheaper inventory is flowing through COGS, but if sales outpace inventory accumulation, that older, more expensive inventory starts flowing into COGS, causing it to be overstated. Dreary, let’s review a quick example. My company’s inventory consists of 20 units, acquired during the four most recent fiscal quarters. 5 inventory units acquired at $5.00/ea. 5 inventory units acquired at $10.00/ea. 5 inventory units acquired at $15.00/ea. 5 inventory units acquired at $20.00/ea. Inventory balance would be $250.00. So but in the last fiscal quarter I sold 7 units of inventory (while accumulating only 5 units). LIFO COGS = $130 = 5*$20 + 2*$15 FIFO COGS = $45 = 5*$5 + 2*$10 So, Dreary, as you described, sales have “intensified” beyond the pace of inventory accumulation, but notice that the LIFO COGS are still higher. I’m sure we could fabricate some sort of wildly volatile inventory replacement cost trend that would cause a LIFO Liquidation to make FIFO COGS > LIFO COGS for replacement costs that happen to presently be falling, but I don’t see how this aids in our mastery of this material. Okay, I’m done
hiredguns1, yes normally LIFO COGS will be higher than FIFO COGS given rising prices. I just thought they may ask a question to test whether we believe this to be the case all the time. Obviously not as in this LIFO liquidation case. It might be instructive to check the impact of LIFO and FIFO on CFO (if any), and on quick ratio, etc… but I don’t have any questions ready for that. Dreary
So guys, To summarize, can we find a situation where LIFO COGS will be lower than FIFO COGS given rising prices?? If yes, can you provide us with an example as done by hiredguns1? Thanks a lot.
malek, I’ll invent a situation (we’ll see whether others think it’s reasonable). The macroeconomic situation is peak to trough to early upswing. Let’s assume my company begins accumulating inventory during an economic peak, when prices are relatively high. I purchase 5 units of inventory for $20/ea. The economy begins to cool and head towards a trough, but for various reasons my company decides it’s still a good idea to accumulate inventory. I purchase 5 additional units of inventory for $10/ea. Now the worst is behind us and the we’re in an early economic upswing. Prices are beginning to rise again and I decide to accumulate more inventory in anticipation of increased sales. I purchase 5 additional units of inventory for $15/ea. For the sake of simplicity, let’s also assume I haven’t sold anything yet and so my current inventory balance is 5 units @ $20/ea. = $100 5 units @ $10/ea. = $50 5 units @ $15/ea. = $75 Total = $225 I sell 7 units of inventory. LIFO COGS = $95 = 5*$15 + 2*$10 FIFO COGS = $120 = 5*$20 + 2*$10 I’ve made some simplifying and probably unrealistic assumptions here, but hopefully this is at least a remotely plausible situation.
Seems clear to me, Thanks hiredguns1!!
hired, the only problem with your example is that it doesn’t match the question. When you are told in a problem that pricing are rising, they mean that prices have been consistently rising all along (unless they explicitly say that it is not the case) , otherwise it is impossible to draw any type of meaningful conclusion. In your example prices first drop (20 to 10) and then rise (10 to 15)
Super, I agree completely. I can’t think of a way to make FIFO COGS > LIFO COGS for consistently rising prices. Is it possible if we have to write down recently acquired inventory for some reason (e.g. spoilage)? Any other ideas?
If the prices are higher ( you don’t consider buying inventory cheaper because let’s say you buy a bigger quantity and you get a big discount) I don’t think there is any way for fifo cogs to be higher than lifo cogs.
That’s exactly what I was thinking florinpop. But I found people talkinh about liquidation stuff, a notion that I never heard of before…
malek, I think you’ll need to know about LIFO Liquidations for the exam and their implications for inventory balance, COGS and gross profit. But, as we’ve been discussing, given consistently rising prices, this wouldn’t result in FIFO COGS > LIFO COGS.
if there is a liquidation of inventory- your inventory is decreasing, and the prices have been constantly rising, that means that COGS LIFO per unit will decrease and COGS FIFO average will increase up to the extreme point that you sell all your inventory, in which case the two will be equal
FIFO COGS > LIFO COGS under rising prices. Why is that difficult? Day 1: Bought 1 unit at $11 Day 2: Bought 1 unit at $12 Day 3: Bought 1 unit at $13 Day 4: Bought 1 unit at $14 Day 5: Bought 1 unit at $15 Sold 1 unit, then 1 unit, then 1 unit, then 1 unit (until all are sold): FIFO COGS (in order): $11, $12, $13, $14, then $15 LIFO COGS (in order): $15, $14, $13, $12, then $11 Look at the last two sells: FIFO COGS > LIFO COGS Dreary
Dreary - that also is a situation that doesn’t reflect reality. All questions will be about compnaies that are in business, not companies going out of business. Companies don’t sell down all of their inventory, and then restock (which is the scenario that you illustrated, without the restocking). As items are sold, new inventory comes on line throughout the year. In addition, many companies use a periodic system, meaning that they don’t track CGS on a daily basis. Ar the end of the period/year they take BI + Purchases to arrive at goods available for sale, and then subtract ending inventory to come up with CGS. They ignore the actual timing of the inflows and out flows of units within the period and just focus on total numbers for the period.
That would be an inventory liquidation.
Sure, but the question was is such a thing possible, and the answer is most definietly yes. Nonetheless, this is not necessarily abnormal. It all depends on the line of business the company is in, and the kind of inventory strategy it has. As you know, many of the CFAI questions are not necessarily about the average/normal way of doing business. Dreary