LIFO/FIFO CFO question

[noseykibitzer]

Alright...just starting to go over the things that I don't get and still don't get.

LIFO conformity rule - use LIFO for both tax and reporting, now why when LIFO is used for tax purposes would CFO be higher???

Assuming prices and stable inventory under LIFO - CGS would be higher and EBIT would be lower than FIFO, so there would be lower taxes paid and lower net income..still don't get it why CFO would be higher (essentially no change in inventory so that wouldn't play into it)

Another one on the same subject...which I also don't get. this is directly from the material I am using as a supplement to the readings

"if inventory levels decrease and assuming prices have increased over time, then LIFO COGS will be lower than FIFO COGS as the older costs are now included in COGS under LIFO. Not only will NI be higher under these conditions, but the company's tax bill will also be higher and therefore, CFO is reduced"

This one doens't make any sense to be either...prices have increased so you would still have a higher COGS under LIFO even though you are now eating up inventory, FIFO COGS should still be lower because you are using lower priced COGS

Any insight is greater appreciated...Thanks in advance

 

[jamespucyk]

1) The Lifo and Fifo methods of accounting in a taxless environment will have NO effect on cashflow, since inventory accounting methods are different ways to account for inventory on the BS and IS, but they have no effect on CFO.

2) Adding taxes to the environment, higher profits using FIFO will cause a higher amount of taxes paid (IN CASH), therefore lower CFO and vica versa for LIFO. Therefore the only real economic effect of LIFO/FIFO accounting is a positive cashflow effect while using LIFO.
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The above explaination was assuming an inflationary environment and/or a firm accumulating inventory. When there is deflation, i.e. a drop in the general price level or more specifically for the product the firm uses for inventory the opposite is true LIFO account will produce higher Net Profit and lower CFO. The other reason for this to occur is LIFO reserve liquidation, this is when the inventory stated on the IS is older inventory becuase of say an economic downturn and lack of demand for the product.

 

[exemplaria]

1) LIFO/FIFO are just cost flow assumptions, there's no actual cash involved. However, like you said, when prices and inventory are stable or rising, LIFO COGS will be higher, and EBIT and NI will be lower. This means less cash taxes paid. Cash taxes is an operating cash outflow, so CFO is higher.

2) If inventory levels decrease, you will have what is called a LIFO liquidation. Under LIFO, high current prices are allocated to COGS and low older prices are allocated to inventory. Since you are constantly allocating low, old prices to inventory, your inventory level on the balance sheet will likely not reflect reality. This is why companies have to disclose their LIFO reserve. When inventory levels decrease, some of those very old, low costs are allocated to COGS. This reduces COGS relative to what it would have been if more recent costs had been used. These old costs reflecte din inventory are called LIFO layers, and when an old LIFO layer gets allocated to COGS, it's called a LIFO liquidation. COGS is artificially low, NI is higher and the tax bill is higher.

 

[Casetap]

Thanks, that makes things clearer now.

 

[noseykibitzer]

Comparing this to what you guys have said makes it clear

Assume these numbers


FIFO LIFO
Sales $25,000 $25,000
_____________________________________
Begin Inv 1,000 1,000
Purchases 22,200 22,200
End Inv 11,700 9,100
_____________________________________
COGS(-) 11,500 14,100

Gross Profit 13,500 10,900
Operating Exp(-) 5,000 5,000
_____________________________________
EBIT 8,500 5,900
Tax 30%(-) 2,550 1,770
_____________________________________
NI 5,950 4,130

Using these numbers

Net increase in inventory under FIFO is (11,700-1000) = 10,600 (decrease in CFO)
Net increase in inventory under LIFO is (9,100-1000) = 8,100 (decrease in CFO)

Taxes under FIFO = 2550 (decrease in CFO)
Taxes under LIFO = 1770 (decrease in CFO)

NI under FIFO = 5.950 (positive CFO)
NI under LIFO = 4,130 (positive CFO)

CFO under each method

FIFO LIFO
+5,950 +4,130
-10,600 -8,100
-2550 -1,770
________________________
-7,200 -5,740

FIFO's higher net inventory balance than LIFO, and consequently lower COGS and higher EBT, will cause higher taxes and a greater netting out effect on CF even though NI is higher than LIFO...the difference in CFO is just as attributable to the differential increase in inventory balance (net CFO outflow) as it is to taxes.

That is where it wasn't making any sense to me when they were just talking about the tax effect on CFO. Thanks

 

[exemplaria]

Nosey,
While it is true that in your example above, differences in CFO are due it part to changes in working capital, normally a firm using FIFO will have a higher beginning inventory balance than a firm using LIFO. So the effects of working capital on CFO are unknown.

 

[jamespucyk]

The caveat here are "everything else equal" CFO is higher under LIFO as exemplaria pointed out.