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Level I CFA: FRA Inventories-Lecture 2 - YouTube
Channel: IFT
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now we come to one of the most important
[3]
aspects of this reading which is to
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understand
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the lifo method and how to convert lifo
[9]
numbers
[9]
into five four numbers as i mentioned
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before
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lifo is permitted under u.s gaap and it
[16]
is not permitted
[17]
under ifrs there is a rule called the
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lifo conformity rule which is very
[22]
important
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and this rule says that the same method
[26]
must be used for tax reporting and
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financial reporting in other words if
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you are using lifo for your financial
[32]
reporting
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then that same method is used for
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tax reporting this is different from
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depreciation
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with depreciation you are allowed to use
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straight line method or whatever method
[45]
is appropriate for financial reporting
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and a different method for
[50]
tax reporting okay now in this
[52]
particular case
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if a company wants to reduce its taxes
[58]
it can use the lifo method in the united
[60]
states because that's where it is
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allowed lifo method reduces earnings
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before tax and then
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reduces taxes i mentioned this before
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also
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however companies which use the lifo
[73]
method
[74]
must also disclose something called the
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lifo reserve
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life or reserve is the difference
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between inventory reported at fifo
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versus inventory if it were reported
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using the
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lifo method
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this particular section he has two
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subsections section
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point one will get into the details of
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lifo reserve
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and then section two will deal with lifo
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liquidations here is the formal
[102]
definition of the lifo reserve
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it is the difference between the
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reported lifo
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inventory carrying amount and the
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inventory amount that
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would have been reported if the fifo
[114]
method had been used
[117]
u.s gaap requires that if you do
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use lifo numbers then in the footnotes
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you disclose the lifo reserve
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so that financial analysts can easily
[128]
convert
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from life or numbers to fifo numbers
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this lifo reserve is extremely important
[135]
in
[135]
several adjustment related calculations
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that you will
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need to make you look at
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the balance sheet of a company that is
[145]
using the
[146]
lifo method the inventory number shown
[149]
on the balance sheet
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is the inventory number that is
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calculated based on
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lifo so how do you convert that into
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fifo inventory or inventory that would
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have been reported if the company had
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used
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fifo just looking at this definition all
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you need to do is add the
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lifo reserve number so if the reported
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number is
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150 and in the footnotes you see that
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the lifo reserve is 25
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then you simply say that the fifo
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inventory is
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175. then
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you go to the income statement and you
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want to convert
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the reported cogs number from lifo to
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fifo
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if the reported cogs number let's say
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is 100 since the company is
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using lifo the reported number is based
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on
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lifo how do you convert this to
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fifo what you do is the following
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you take the lifo cogs as your starting
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point and then you
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subtract the change in lifo reserve
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change in life for reserve is the ending
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lifo reserve minus the
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beginning lifo reserve
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if your life for reserve at the end of
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the period
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is 25 and the lifo reserve
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at the beginning of the period is 20
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then what is the change
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in life or reserve that change is
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five and you will have five four cogs of
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95. so fairly straightforward
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next point obviously you might also want
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to look at the impact or net income
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if you are comparing the net income of
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two companies or you are comparing
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ratios such as net profit margin and so
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on where net income is required
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then you need to make a net income
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conversion
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fifo net income is equal to lifo net
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income
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plus the change in lifo reserve
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into one minus the tax rate so you need
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to remember
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this relationship and then the fifo
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retained earnings
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is equal to lifo retained earnings plus
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lifo reserve into one minus t
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there are several relationships here and
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i'll suggest a method for
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remembering all these relationships this
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one is easy
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why because this is simply the
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definition
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also note that there are two
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relationships here which are
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balance sheet based and there are two
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relationships which are income statement
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based
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the top one is a balance sheet
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relationship
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and the bottom one is a balance sheet
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relationship the balance sheet reports
[326]
cumulative numbers in the sense that
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you are looking at your total inventory
[330]
at a given point in time
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or your total accumulated retained
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earnings
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with balance sheet related calculations
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we use the ending value
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of the lifo reserve and then obviously
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with retained earnings there's going to
[347]
be a tax in fact so you do
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one minus t the middle two
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expressions here are related to the
[354]
income statement
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whenever you are dealing with the income
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statement there you
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consider the change in life or reserve
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so notice that
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there is a change in life for reserve
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so this will help you remember where to
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use the lifo reserve
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versus where to use the change
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that's point number one point number two
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is where do you plus and where do you
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minus
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because it is easy to imagine questions
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which are testing
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you as to whether you know whether to
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plus or minus
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okay hopefully you recognize the fact
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that in
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an environment of rising prices which is
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the typical environment
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fifo inventory is going to be more than
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life for inventory so that's why you
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have a
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plus sign you also recognize that in the
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typical environment where prices are
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rising
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four cogs will be lower than life of
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cogs
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so that explains the minus sign
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phi for net income is going to be higher
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so that explains the plus if net income
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is higher then
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retained earnings will also be higher so
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that
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explains the plus
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and then the third point how do you
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remember this one minus t
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obviously if your income is going to be
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higher there is also going to be a
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higher tax
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so the impact of tax needs to be taken
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out
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and that's where the one minus t comes
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into play
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before i come to the definition of lifo
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liquidations
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i'll just give you some high level
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points in periods of rising
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inventory the carrying amount of
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inventory under fifo will exceed the
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carrying amount of
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inventory under lifo
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i'll give you a very straightforward
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example to illustrate this point
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let's say that you are buying inventory
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and you first buy
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at one dollar a piece then you're buying
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it two dollars a piece then you are
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buying at
[484]
three dollars a piece so this is time
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in periods of rising inventory which
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means that your
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inventory balances are increasing
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and let's say that you are using the
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fifo method
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if you are using the fifo method then
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you are selling
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the low cost inventory your inventory
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balances are rising which means
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that inventories that are valued
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higher those balances are rising
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so the difference between fifo and live
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4 keeps increasing
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and the difference between 5 4 and lifo
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is the
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life or reserve so that is the
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straightforward point being made over
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here
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so these are two sub points that you
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need to remember
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the lifo reserve may increase for two
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reasons increasing difference between
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older costs used to value inventory
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under lifo
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and more recent costs used to value
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inventory under fifo so that's
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illustrated by this
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simple example also the number of units
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manufactured or purchased
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exceeds the number of units sold so if
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these two things
[554]
are happening then you have an increase
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in
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lifo reserve lifo liquidation
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refers to the opposite scenario
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if you have a situation where the number
[568]
of units
[569]
sold exceeds units
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purchased or manufactured then you have
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lifo
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liquidation now coming back to this
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scenario
[580]
a company is using lifo
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and the units being sold
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exceeds the units being purchased or
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manufactured
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that means that a company then is
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dipping into these older layers
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and a company might be selling over here
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but
[599]
now the cogs is indicating that you are
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selling inventory that is only worth
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one dollar so this is called lifo
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liquidation where you are dipping
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into old cost or low cost
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inventory what will that do to your cogs
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it will make the cogs appear low
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relative to current prices and what will
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that do to gross profit
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it will make the gross profit look high
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but will this high gross profit be a
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good indication of what you can expect
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in the future
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no because in the future obviously
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you'll be buying at current prices
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so as an analyst if you observe
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a decrease in the lifo reserve then that
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is a warning sign
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that the current profits are higher
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than what you can expect in the future
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this can also be used by management to
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manipulate earnings
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if management wants to show higher
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earnings
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then potentially they can do things that
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allow them to dip into old inventory
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so you as an analyst need to be careful
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whenever you see
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lifo reserves decreasing
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all right now here is a quick
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check of whether you are understanding
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what's going on
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i want you to think about this come up
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with an answer before i give you the
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answer
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the correct answer is company a and how
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do we know this
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first of all when you have lifo versus
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fifo and you are talking about an income
[699]
statement item
[700]
immediately you know that it's going to
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be
[704]
lifo and not fifo
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then you also need to consider what's
[711]
happening to the lifo reserve
[713]
a decrease in lifo reserve means that
[717]
there is
[717]
lifo liquidation taking place and cogs
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is reflecting
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old prices because we are dipping into
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older layers
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so that would mean that between a and c
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company a is the better answer
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so fairly important you might see
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questions like this at the end of this
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reading
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you
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