The FIFO/LIFO Choice and Inventory Holding Policy

Hey All! On pg. 326 of Financial Statement Analysis it says it was found that, “LIFO firms tend to maintain higher inventory balances (in units) than comparably sized FIFO firms. This finding is consistent with the following three factors: 1. Firms with higher inventory balances have larger potential tax savings from the use of LIFO. Thus, the higher inventory levels that result from the firm’s production and operating environment may explain why the firm chose LIFO in the first place. 2. These higher balances may result from the LIFO choice, as LIFO firms attempt to get the most advantage from it by increasing their inventory levels…” ------------------------------------ I’m trying to figure out why having higher inventories equate to higher tax savings. I can understand that using LIFO increases tax savings because assuming rising prices, net income would be lower, but I don’t understand why higher inventories will get higher tax savings. Is there some tax credit for inventories that I don’t know of? That seems silly. Thanks!

If a company uses LIFO and their inventory starts to decline then lower inventory costs will be paired with higher revenues resulting in higher profit and higher taxes. If inventories continue to rise within reason, the costs paired with the sales will be higher and result in less profit and lower taxes. I believe this is correct.

I would reason that if a firm holds a high inventory then they also have a higher volume of sales. This means that they will deplete their inventories faster than other firms with a lower sales frequency and need to ensure that they keep a good bit of inventory on hand to ensure that they have enough supply to meet the demand for the product. An example I can think of would be a super market. They keep a certain amount of goods on the shelf; but, maintain a warehouse full of inventory to restock the shelves as shoppers purchase goods. When the inventory gets to a certain level, say 40%, they will order more inventory to ensure they don’t run out of goods and lose future revenue. Since they are selling inventory at a rapid rate, they will receive a greater tax benefit by using LIFO to report the higher cost of replacing inventory. This is assuming they are operating in an inflationary environment. A firm with lower sales would purchase inventory less frequently and would probably not benefit as much from LIFO’s tax savings when creating their financial statements for tax purposes. An example I can think of for this instance would be an art gallery. They would have several pieces for sale; but, the sales cycle would be much longer and they would purchase a new piece of artwork after they sell one or two. Since they are purchasing inventory at a slower rate, LIFO would not help much because by the time they sell the artwork, prices would have potentially raised several times over. So, in essence, they miss out on the value of the tax benefit. So, the firm that has a higher frequency of sales, or a shorter sales cycle, will keep more inventory on hand will use LIFO to make COGS keep up with the rate of inflation and reap a tax benefit due to the lower reportable income. The firm with the lower rate of sales, or longer sales cycle, will probably be indifferent between which method to use because the maximum potential tax benefit will be outpaced by the rate of inflation. Now I’m off to party and drink–it’s Friday night!

For me Libre27 explanations look reasonably but anyway…I went through FSA and did not pay attention to that sentence… Anybody with other explanations?

Suppose that higher inventories = older inventories. If you are holding stuff produced 40 years ago, you get whacked on taxes when you sell it.

JoeyDVivre - but haow it answers the question asked?

They also have higher claims for depreciation of assets.