Pretty basic LIFO to FIFO question I may be overthinking

[Mosstastic]

Let’s assume we have the following:
Cash: 1,100,000
Inventory: 2,400,000
LIFO Reserve (Jan 1): 600,000
LIFO Reserve (Dec 31): 900,000
Retained Earnings: 1,500,000
Tax Rate: 40%
Now, if I am trying to find what the new assets-to-equity ratio would be under LIFO, I calculate my inventory levels by adding back the 900,000 if LIFO Reserve
New Inventory Level: 2,400,000 + 900,000
Here’s where I get confused, when figuring out the additional taxes paid, I would have taken the change in LIFO Reserve (300,000) and calculated my tax shield…
300,000*.4 = $120,000 extra cash paid in taxes
My rationale here is that my COGS would have been reduced by 300,000 thus increasing my taxable income yadda yadda…. but in this example we are told that cumulative pretax income would also be higher by $900,000, so taxes paid would be higher by .4 ($900,000) = $360,000. Therefore cash would be lower by $360,000.
I can’t seem to follow the above logic. Why are we using a tax shield on the entire LIFO reserve?

 

[S2000magician]

Because your adjustment is trying to determine how the financial statements would look if you had been using FIFO all along.
Because the balance sheet is an an accumulation of value since time immemorial, the adjustments on the balance sheet are for the full amount of the LIFO reserve.
Because the income statement covers only one year, the adjustment (for each year’s income statement) is only the incremental LIFO reserve for that year.

 

[Mosstastic]

S2000magician wrote:
Because the income statement covers only one year, the adjustment (for each year’s income statement) is only the incremental LIFO reserve for that year.

So I could take this to mean that we’re taking into consideration all of the previous LIFO reserve changes too… theoretically speaking? (when calculating our additional tax paid).
And one more thing… is this how it’s truly done in the “real world”? If Firm A converted from LIFO to FIFO, would his tax shield actually be ending LIFO reserve * tax rate? Or are we just using this adjustment for a comaprison basis?
If we’re just using it for a comaprison basis, why would I want to comapre how firm A (using FIFO) comapred to firm B using (LIFO) after an adjustment made for all prior LIFO reserve changes (if my assumption above is correct). That doesn’t seem to give us an apple to apple comaprison for that year

 

[Mosstastic]

I am just now realizing, since we’re looking at assets-to-equity, we would want to take into consideration all of the prior adjustments made, not just for this particular year…
long day

 

[S2000magician]

Mosstastic wrote:

S2000magician wrote:Because the income statement covers only one year, the adjustment (for each year’s income statement) is only the incremental LIFO reserve for that year.

So I could take this to mean that we’re taking into consideration all of the previous LIFO reserve changes too… theoretically speaking? (when calculating our additional tax paid).

Yup.

Mosstastic wrote:And one more thing… is this how it’s truly done in the “real world”? If Firm A converted from LIFO to FIFO, would his tax shield actually be ending LIFO reserve * tax rate?

Yes. In general, if you change an accounting method (e.g., changing from LIFO to FIFO, or changing from straight-line to accelerated depreciation), you have to do so retrospectively: as if you had used the new method since time immemorial. (The one exception is changing to LIFO (under US GAAP): that one’s done only prospectively.)

Mosstastic wrote:Or are we just using this adjustment for a comparison basis?

Both.

Mosstastic wrote:If we’re just using it for a comparison basis, why would I want to compare how firm A (using FIFO) compared to firm B using (LIFO) after an adjustment made for all prior LIFO reserve changes (if my assumption above is correct). That doesn’t seem to give us an apple to apple comparison for that year

It gives you an overall comparison, as close to apples-to-apples as you can get. The balance sheet is adjusted to reflect all historical effects of the change, and the income statement is adjusted to reflect that year’s effects of the change.

 

[Mosstastic]

Understood, very helpful. Thanks again!

 

[S2000magician]

Good to hear.
You’re quite welcome.