LIFO -> FIFO effect on retained earning

2005 LIFO reserve 50,000 2006 LIFO reserve 60,000 Tax is 40%. What would be the effect on retained earning had the firm uses FIFO? It’s 36,000. Reserve * tax rate, but I just don’t get it? Any explanation?

The formula says: Fifo profit = Lifo Profit + [^Lifo reserve x (1-tx rate)] You need the Lifo Profit (which I am thinking was given, and 30,000) Bcse 10,000 x (1-.4) = 6,000. So, 30,000 + 6,000 = 36,000. Otherwise I don’t know how you would know… Anyone else?

Is it $10k (0.6) = +$6k?

use change in LIFO reserve while adjusting NI.

Hmm… I would have approached it like this… We know that LIFO COGS for a given periods is equal to LIFO COGS less the change in the reserve. So here, the reserve increased by 10,000… so COGS under LIFO would be 10,000 less if you had used FIFO. This would mean that you would have had $6000 more in net income for the period if you had used FIFO rather than lifo, since $10,000 *(1-t) = $6,000 Now that just reflects the impact of one period. By 2006, you have a lifo reserve that has grown to $60,000. If you reserve that entire bad boy, then you subtract $60,000 from LIFO cogs. $60,000 * (1-t) = $36,000… the benefit to net incomes (which flows out to retained earnings completely if the firm is not paying a dividend).

Nope LIFO profit is not given that’s all the information on the question. I don’t understand this myself. I think mcf explanation is quite good, still trying to understand it but.

fifo cogs = lifo cogs - increase in lifo reserve so fifo cogs would decrease by 10k and ni would increase by 10k 10k * .4 = 4000 so profit and retained earings would increase by 6k

No Net Income will increase by 6K but retained earning by 36k. That’s what the answer is.

You don’t need NI for this, you are only looking at the impact on NI. NI_fifo = NI_lifo + Delata_LIFO_reserve (1-t) take an example: $92 = $80 + 20(0.6) The difference in NI is $12 which is $20(0.60)

ive just googled it and you must increase retained earnings by lifo reserve * (1 - tax rate)

d: Describe the effects of adjustment from LIFO to FIFO on inventory balances, cost of goods sold, and income. Adjustment for inventory balances: Add the LIFO reserve to LIFO inventory. This transforms LIFO inventory to FIFO. Now, since you changed inventory on the left side of the balance sheet to current cost, the left side of the balance sheet doesn’t balance with the right side. So, you must then: increase retained earnings by the LIFO reserve times (1 – t). Retained earnings increases, because accumulated FIFO profits would be greater than LIFO profits. Increase deferred tax liability by the LIFO reserve times the tax rate, t. This deferred tax liability would exist if LIFO were used for taxes and FIFO for the financial statements. Adjustment of cost of goods sold The next step is to adjust the LIFO income statement to an approximation of a FIFO income statement. The COGS adjustment uses the difference in the beginning and ending LIFO reserves. The change in the LIFO reserve between two years represents the impact of using LIFO during that year. During periods of rising prices, LIFO

so if you raise fifo inventory by lifo reserve (60k) you have to balance the other side of th a = l + e equation. dtl up by lifo reserve * tax rate and retained earnings up by lifo reserve * (1-t)

FIFO Inventory = LIFO Inventory + LIFO Reserve I would think its simply the LIFO Reserve X (1-tax rate)

Intuitively this adjustment to Retained Earnings makes sense to balance the A = L + E equation. However, if we purely base RE on its true formula where :

Retained Earnings = Net Income + …

And we know that NI is increased by Lifo Reserve Delta * ( 1 - Tax rate)

Hence, this would mean that Retained Earnings is ONLY increased by LIFO Reserve DELTA (1 - Tax Rate) rather than by the full Ending Balance of LIFO reserve.

Could someone please clarify?


Not sure i follow your question, but by having a LIFO Reserve of $60k, the effect on RE is +$60k (through the reduction in COGS) less the tax payable (pre-tax profit will be higher due to lower COGS). Therefore $60k*(1-0.4)=$36k

Thanks for the feedback. The question is why are you adding $60K before taxes rather than only the DELTA of $10K ($60K - $50K) just like when you adjust Net Income?

I guess the answer is because Net Income can only speak for the last period whereas the balance sheets gets the entire LIFO reserve balance flushed into Inventory - Cash paid for taxes after FIFO conversion…

That’s right. Retained earnings is cumulative. Net Income only applies for the particular period. If the question stated what was the effect to retained earnings from the adjustment to NI for 2006, you would reduce COGs by $10k and reduce by the tax implications due to the lower tax shield. This would equal an additional $6k in NI which would flow through to retained earnings.

Awesome! Thanks!