Lifo vs fifo when prices decrease

CFA Level II FRA
#1

Hi,

The question of the day from Schweser tells that in a price-decreasing environment, cost of good sold with LIFO would be smaller than for FIFO (I agree) but the after cash flow would be smaller. I do not understand the answer: if costs are smaller, applying to both method a proportional tax rate would lead to higher after-tax cash-flow, no (everything else held constant)?

Thanks

#2

The only difference in cash flow is taxes. You have higher EBT under LIFO when costs decrease than you do under FIFO, so you have to pay higher taxes. That’s a bigger cash outflow.

#3

Thank you but you have also a higher operating cash flow no?

#4

Yup, CFO = NI + NC - WCInv

NI captures the saving on taxes.

#5

No.

Think about the direct method of CFO:

  • Cash received from customers: no change
  • Cash paid to suppliers: no change (you paid some amount of cash to your suppliers this year; which inventory method you use to account for the costs doesn’t change that)
  • Cash paid for operating expenses: no change
  • Cash paid for interest: no change
  • Cash paid for taxes: higher under LIFO with decreasing costs than under FIFO

Your CFO is lower, only because of the change in income taxes.

#6

Think about this again.

Net income is higher, of course, by:

ΔLIFO Reserve × (1 − tax rate)

But WCInv is also higher by:

ΔLIFO Reserve

Therefore, CFO is lower by:

ΔLIFO Reserve − ΔLIFO Reserve × (1 − tax rate) = ΔLIFO Reserve × tax rate

That’s the additional taxes you pay because net income is higher.

#7

Excellent! Thanks a lot!

#8

Oops, my bad, obviously if the company bears more taxes, its CFO will be lower and viceversa.

Sorry.