# FSA LIFO/FIFO Question

Question: In translating from LIFO to FIFO, the increase in net income is calculated as the after-tax increase in the reserve. This makes sense to me and there is no issue. However, the increase in retained earnings is calculated as the after-tax reserve for the current period. This seems counterintuitive to me. I would think the retained earnings would increase by the amount of increase in net income. Can anybody help to clarify???

You can refer to Questions #3 and #4 on page 43 of the curriculum

Refer to the other post.

I’m not sure why this is so either! If NI is adjusted as NI_FIFO = NI_LIFO + *change* in LIFO reserve multiplied by (1-tax), why is retained earnings adjusted as R.E._FIFO = R.E._LIFO + LIFO reserve multiplied by (1-tax)?

when you move from LIFO to FIFO it is a one time move… and at that time the entire LIFO reserve would increase the Retained Earnings.

But why wouldn’t that increase NI by the same amount? This is where I’m confused. It seems that NI would increase by let us say \$10 million, but R.E. would jump by \$100 million if we switch to FIFO.

2 impacts on RE 1. due to NI 2. due to tax impact of moving from LIFO to FIFO.

cpk has it. Don’t think of this as accounting cost flow assumptions flowing through the financial stmts. Think of it as an adjustment an analyst is making to some financial statements, most likely for comparibility.

Think of the LIFO reserve as the cumulative of all the net income that has been not reported on the income statement due to it being locked up in COGS. When you switch to FIFO, the value of the LIFO reserve flows out of COGS and into inventory, as a result raw net income increases by that amount, and when you subtract tax, your retained earnings increase by LIFO-res(1-tax)

cpk123 Wrote: ------------------------------------------------------- > 2 impacts on RE > 1. due to NI > 2. due to tax impact of moving from LIFO to FIFO. cpk, sorry the explanation is not “convincing”… what you say above applies to both R.E. and NI. Tax impact also affects NI, so if you save tax, it improves your NI *and* R.E.

Andrew3032 Wrote: ------------------------------------------------------- > cpk has it. > Don’t think of this as accounting cost flow > assumptions flowing through the financial stmts. > Think of it as an adjustment an analyst is making > to some financial statements, most likely for > comparibility. Andrew, thanks I saw your reply in the previous thread and that’s why I got confused. I think (with all due respect of course…we are here trying to figure out things), that no one has stated the correct reason for the apparent discrepency in NI and R.E. adjustment due to FIFO/LIFO… except possibly the next reply, so let me check.

Palantir Wrote: ------------------------------------------------------- > Think of the LIFO reserve as the cumulative of all > the net income that has been not reported on the > income statement due to it being locked up in > COGS. > > When you switch to FIFO, the value of the LIFO > reserve flows out of COGS and into inventory, as a > result raw net income increases by that amount, > and when you subtract tax, your retained earnings > increase by LIFO-res(1-tax) Almost correct or I didn’t read your reply well… The issue here is rather simple after you think about it carefully… U.S. GAAP rules require that you restate your financial statements after the switch to FIFO. There is a reason for that. As we saw, the impact of the switch on NI is incremental while that on R.E. is cumulative. Therefore, if you show only this period’s impact, we don’t see the full picture…we only see that NI is up by \$10 million and R.E. up by \$100 million. But if you look at all previous restated statements, you will see that total NI adjustments total up to \$100 million.

http://findarticles.com/p/articles/mi_m0ITW/is_2_85/ai_n14897182/ http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AccPrimer/inventory.htm The following is excerpted from the stern paper There are three basis approaches to valuing inventory that are allowed by GAAP - (a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income. (b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income. © Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this approach will more closely resemble FIFO than LIFO. Firms often adopt the LIFO approach for the tax benefits during periods of high inflation, and studies indicate that firms with the following characteristics are more likely to adopt LIFO - rising prices for raw materials and labor, more variable inventory growth, an absence of other tax loss carry forwards, and large size. When firms switch from FIFO to LIFO in valuing inventory, there is likely to be a drop in net income and a concurrent increase in cash flows (because of the tax savings). The reverse will apply when firms switch from LIFO to FIFO. Given the income and cash flow effects of inventory valuation methods, it is often difficult to compare firms that use different methods. There is, however, one way of adjusting for these differences. Firms that choose to use the LIFO approach to value inventories have to specify in a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is termed the LIFO reserve. This can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based upon FIFO valuation.