Dear colleagues, My question relates to CFAI FRA book, specifically Reading 21 on p.23 Solution 3 where it is mentioned that “…LIFO liquidation has generated positive cash flow which is reduced by its tax impact…” I understand that LIFO liquidation leads to increased profits and consequently tax cash outflows but how does it generate positive cash flows since the book mentions on p.18 Solution 4 in the same Reading that “…the effect on a company’s net cash flow from operating activities is limited to the impact of the change on income tax paid…”?? Thank you in advance!
"LIFO liquidation has generated positive cash flow " - they sold a bunch of stuff that had been sitting in a warehouse gathering dust generating cash “which is reduced by its tax impact” - unfortunately their basis in the stuff in the warehouse was much less than what the sold it for so they had to pay lots of taxes on it from the cash they collected by selling it. So translated “We sold a bunch of old stuff that we bought cheap. That sounds great but we ran up a heck of a tax bill doing it. Our LIFO accounting doesn’t look so great to us now so we fired the CFO and we are using his paycheck to fund the tax liability. Bastard.”
It sounds like (from your post) that there is some confusion between Profits/ Income and Cash Flow. Income aka Profits has non cash components to it and therefore is an accrual number not a cash number. The reason why LIFO inventory cost assumption increases profits is due to the link between the balance sheet and the income statement. I use little mnemonics sometimes to try and remember things, so I think that LIFO empties like an elevator. The people closest to the door spill out of the elevator first, and coincidentally these are also the last ones in. Likewise, in a rising cost environment the newer/ higher costs will be transferred from the inv. acct. (balance sheet) onto the income statement in the form of COGS > Reducing Gross Profits > This will carry down to a depressed EBT > Which therefore reduces the tax burden, as you have stated above. If we now look to the inventory account on the balance sheet what we have retained in that inventory account are the older, cheaper costs. When a LIFO liquidation occurs the purchasing manager is not making additional purchases (this isn’t always exactly the situation but I’m simplifying here to make a point), and the controller begins to transfer these older cheaper costs from the balance sheet onto the income statement in the form of COGS (which will now be relatively lower). Voila! Instant *temporary* boost to gross margin, not because of anything that happened in the real world but b/c of a little snafu in our accrual accounting measures. If we now turn our attention to the cash flow statement, let’s say we are putting it together using the indirect method. We automatically begin with higher NI, further down we will be increasing the CFO because of the liquidation of the inventory account, offset presumably to a lesser extent by an increase in the A/R balance. We have now *temporarily* boosted our CFO for the current period. The key that produces this temporary boost is that no additional purchases are being made, or there are less purchases than units sold that allow us to transfer these older cheaper costs retained on the balance sheet to the income statement *In the event of a LIFO Liquidation. Unfortunately, capital market participants are not fooled by our accounting shenanigans, our stock price has just dropped to .05, and some assh*le from the SEC is now calling our office phone and we will be going to Federal pound me in the A$$ prison. Good news is that vasoline is on sale at Walgreens. Better get two jars!!
The answer in curriculum has mixed two different points. 1. Reduction in inventories results in positive operating cash flow impact. 2. LIFO Liquidation results in negative operating cash flow impact due to higher taxes.
There’s no mix up in points (see above) this is a *LIFO liquidation, i.e. a special case of the LIFO cost assumption NOT normal cause and effect from using a LIFO cost assumption. If you just read above it describes it in full.
Thank you guys for the immediate response!