LIFO to FIFO reserve and tax implications

I am having a hard time grasping something and would like anyone that can help, help clarify so I can move on.

Can someone explain to me how to calculate the cumulative tax savings for using LIFO instead of FIFO?

For example in the CFA books, reading 17 example 2. Question 5 asks this exact question. My thought would be to use the ending LIFO reserve for 2007 and mutliply by the tax rate and add that with the ending LIFO reserve for 2008 multiplied by the 2008 tax rate. However, the solution says to use ending reserve from 2007 but change in reserve for 2008. Why are we swtiching it up here? Why not use the change for both years or the ending reserve for both years?

Also, lets say the tax rate never changed between 2007 and 2008. would the calcuation differ?

LIFO reserve represents the cumulative amount of income undierstatement over the years. If you want to find out how much taxes you would have paid had you not understated your income:

A. Decompose the pile into individual buckets which were taxed at different rates. Say the cumulative amount is 100k accumulated evenly over 10 years. Tax rate for year 1-5 was 50%, tax rate for years 6-9 was 40% and tax rate for year 10 was 30%,

Tax saved = (5x10,000x0.50) + (4x10,000x0.4) + 10,000 x 0.30 = 44,000

B. Same info as above except tax rate was 40% throughout. In that case, no need to decompose - entire 100k would be at 40% and tax saved = 40,000

That’s a great explanation CMLSML! Nice!

Thank you for the response CMLSML, but isnt your explanation only confirming my orignal thought, that the book says is wrong?

Let me put some specific numbers into it:

2006 ending LIFO reserve = $2,412.

2007 ending LIFO reserve = $2,617

2008 ending LIFO reserve = $3,163

Tax rate from 2007 to prior = 20%

Tax rate in 2008 only = 30%

What is cumulative tax savings by using LIFO?

Book says to calculate like this: (20% x $2617) + (30% x ($3613-$2617))

My question is why are we calculating by taking the ending LIFO reserve from 2007 but only the change in LIFO reserve for 2008?

Let’s try approaching this from the other direction; maybe it’ll be easier. Your total tax savings will be your saving in 2008 plus your saving in 2007 plus . . . (I’ll abbreviate tax saving as ts):

Total savings = ts08 + ts07 + ts06 + ts05 + . . .

Each year, your tax saving is the tax rate (tr) times the difference between FIFO COGS and LIFO COGS, and that difference is the change in the LIFO reserve (ΔLR):

Total savings = (tr08 × ΔLR08) + (tr07 × ΔLR07) + (tr06 × ΔLR06) + (tr05 × ΔLR05) + . . .

We’re told that:

  • tr08 = 30%
  • tr07 = tr06 = tr05 = . . . = 20%

So,

Total savings = (30% × ΔLR08) + (20% × ΔLR07) + (20% × ΔLR06) + (20% × ΔLR05) + . . .

Because all of the terms before 2008 have a tax rate of 20%, we can factor that out (sorry: algebra):

Total savings = (30% × ΔLR08) + [20% × (ΔLR07 + ΔLR06 + ΔLR05 + . . .)]

Now, the question is, what’s that sum in the parentheses? Remember, the LIFO reserve is the cumulative (i.e., sum of all of the) changes in the LIFO reserve since the beginning of time, so that sum is the 2007 ending LIFO reserve (LR07):

LR07 = ΔLR07 + ΔLR06 + ΔLR05 + . . .

So,

Total savings = (30% × ΔLR08) + (20% × LR07)

That’s what the book has.

Ok Ok, finally got it, makes sense to me now. Thanks a lot for the reponse and effort you put in to that. Extremely helpful!!

Good to hear.

My pleasure.

I’m glad that it was.

S2000, that’s awesome! Thanks!

You’re too kind.

You’re welcome.

Hi there,

the cumulative operating tax saved is also used in the conversion of Retained Earnings.

I understand the concept.

What I don’t understand is that sometime, depending on the item set. We calculate the Retained earnings considering previous years cumulative operating tax saved and sometime we don’t

Case 1 : RE (FIFO) = RE LIFO + increase in LIFO reserve x (1-t) + LIFO reserve of previous year x (1-t)) (example Q6 p17 of CFAi FSA book)

Case 2 : RE (FIFO) = RE LIFO + increase in LIFO reserve) (Practice problem Q4 p39 of CFAi FSA book)

how can we know which one to use.

if you have any idea, it would really help. good revisions

Truly impressive, sir.

Hello I have come across a very similar question recently except that it specifies only the tax rate for two years out of the 3-year data provided in the question.

Question: What is the cumulative amount of income tax savings that CAT has generated through 2017 by using the LIFO method instead of the FIFO method?

The LIFO reserve for 2015, 2016 and 2017 are as follows, 2,498, 2,139 and 1,934.

The difference between year 2016 & 2015 and year 2017 & 2016 reserve, is - 359 and - 215.

Tax rate for 2017 and 2016: 28% and 36%.

With these information, I thought the cumulative tax savings calculation would be (-359 x 36%) + (-215 x 28%), as opposed to the answer provided, which was (-215 x 25% + 2,139 x 36%).

I understand @S2000magician 's elaborated and helpful response, but in my context, shouldn’t the calculation be (36% × ΔLR2017) + (28% × ΔLR2016). Does anyone know why the answer would be (36% × ΔLR2017) + (28% × LR2016)?

This question is quoted from Financial Reporting and Analysis textbook, p. 328 Example 5, question 5, under 4.2 LIFO liquidation.