Hello, I'm Professor Brian Bushee and welcome back. In this video, we're going to take a look at a disclosure of a company that uses LIFO. One of the things that you may have to do at some point is compare a firm that uses LIFO to a firm that uses FIFO. If you do that, you need to convert the LIFO firm to a FIFO basis to make any kind of reasonable comparison between the two because ending inventory and the cogs are so different between the two methods. That you really can't compare them without adjusting the LIFO firm through the FIFO basis. So let's see how that happens. Let's get started. To facilitate the comparison of LIFO and FIFO firms. LIFO firms have to disclose what their inventory cost would be under FIFO. That way, we can convert all of the results for the LIFO firm to a FIFO basis. And that's the only direction we can go, there's no way that we can convert a FIFO firm to LIFO. If you think about it, it'd be a pretty daunting task because a company that's always done first in first out would have to go back and look at it's entire history of inventory purchases to redo it under last in first out. But if you are doing it last in first out, it's fairly easy to transfer those results to first in first out. So what we are going to get in the disclosure is something called the LIFO Reserve. The LIFO Reserve is the difference between what the ending inventory would be under FIFO, first in first out. And what the inventory is under LIFO, which is what they disclose on the balance sheet. To adjust the income statement, we can use the fact that the change in the LIFO reserve is equal to LIFO COGS- FIFO COGS. So what we're trying to figure out for the LIFO firm is what it's COGS would be under FIFO. So that means that FIFO COGS would equal LIFO COGS, which is what was disclosed in the income statement minus this change in the LIFO reserve. And then translating that to net income, the FIFO in that income would equal LIFO net income, plus the change in LIFO reserve times one minus the tax rate. We have to multiply the change in LIFO reserve times one minus the tax rate to take an after tax version because with net income, we're looking an after tax number. And notice that when we're dealing with COGS, we subtract the LIFO reserve but with net income, we add it because COGS is an expense. Whereas net income is revenue minus expenses, and then the last things I have up here are tax savings during the current year. Are the change in the LIFO reserves times the tax rate? And the tax savings cumulatively over the whole LIFO the firm will be whatever the balance in the LIFO reserve is times the tax rate. >> Sorry, I zoned out for a second. What is the triangle thing? And when would we ever have to do this again? >> Yeah, I think I zoned out myself while reading the words on that slide. A page of formulas is not fun. And I think if I had spent even more time trying to explain the intuition it would have made it even less fun. So to answer your question, the triangle is the Greek letter delta which means change. You will have to use formulas like this if you're ever looking at a LIFO company and want to compare to a company that uses FIFO. Basically, the inventory method has such a distorting effect on ending inventory and cost to goods sold. That the only way you could get a reasonable comparison of those firms, would be to convert the life of firm to FIFO, which we're going to do right now in an example. So let's take a look at an example of a LIFO disclosure. So were going to look at KP Incorporated, which manufactures flux capacitors. And if you don't know what those are, you can just pause right now and search on Wikipedia. KP uses the LIFO method, so if we want to compare KPs results, compare their financial statements to firms that use the FIFO method, we have to switch KP from LIFO to FIFO. Cost of goods sold for KP were 1,855 during 2012. Company's take rate is 35%. Questions that we are going to try to answer from the disclosure are. What is the FIFO value of the inventory? That allows to compare a balance sheet of KP to a balance sheet of a company that uses FIFO? What would be the FIFO COGS in 2012? So if we want to compare the income statement between KP and a FIFO firm? Putting KP in a FIFO basis will facilitate the comparison and then we're going to see how much in taxes KP saved during the year. So here is the disclosure in the footnotes. First thing, I want to point out before we get into the LIFO stuff is this is what the disclosure looks like for the breakdown of raw materials, work in process and finished good. So if you remember couple videos ago, we talked about how manufacturing firms, how these three buckets of inventory? Looks like in KP situation the raw materials and work in process are both up. Their finished goods are down slightly which probably means they're ramping up production and work in process is up. They ordered more raw materials, so maybe they're anticipating even more sales or more production and their finished goods are done, which probably means they're having no trouble selling their inventory. So, those are all indicating that the company is growing well. Now, let's take a look at the LIFO disclosure. So we want to figure out what the LIFO value of the inventory is. The formula is that the FIFO inventory is going to be the LIFO inventory plus the LIFO reserve. So we see the LIFO value of the inventory at the bottom line, 518 and 540. Less revaluation to LIFO, that's the terminology for LIFO Reserve. So in 2012, we take 518 plus 102 to get to 620 and for 2011 we take 540 plus 63 to get to 603. Now, the LIFO Reserve is in brackets and that is representing that let's say credit balance and we're not going to get into the journal entries for that so, don't worry about it. But, it's negative, it's also negative because it's reducing 620 minus LIFO reserve to 518. But when we look at these equations, we just treat the LIFO reserve as a positive number so, we take 518 plus 102 to get to 620. And as you noticed the 620 and the 603, the FIFO value of the inventory is actually disclosed by KP, even though they don't label it as the FIFO value. Now, let's look at what FIFO COGS would have been in 2012, so here, the formula is FIFO COGS is LIFO COGS minus the change in the LIFO Reserve. So FIFO COGS is 1855, which is what we saw before it was something that was given with the problem. You could also find this in the income statement. The change in the LIFO reserve is 102 minus 63, so again, we're ignoring the brackets, we're just taking 102 minus 63. And we subtract that from 1855 to get FIFO COGS of 1816, so the FIFO COGS are 39 less than the LIFO COGS. >> Shall I infer from this example that COGS LIFO is always greater than COGS FIFO? >> No, please don't infer that from this example. The only reason that LIFO COGS are greater than FIFO COGS is that prices have been rising. If prices of inventory had been dropping, then LIFO COGS would be less than FIFO COGS. So, think of it this way. LIFO is Last In First Out. So, LIFO is very sensitive to the direction of price movement. If prices are going up, LIFO COGS will be higher. If prices are going down, LIFO COGS will be lower. The last question we want to answer is, how much did KP save in taxes in 2012 by using LIFO? The formula before is that the tax savings are equal to the change in LIFO Reserve times 35%. Change in LIFO Reserve is, again, 102 minus 63. That's the 39 that was the difference in COGS that we saw before. So, LIFO gave you higher COGS by 39, if we take 35% of that, that's the tax savings based on that higher expense and the tax savings come out to be 13.65. Now it, doesn't it here, but these numbers are in millions, so that's a tax savings of $13,650,000 for KP. >> Those are some nice tax savings. Why does the US government allow companies to use LIFO? It is like letting them shit on taxes. >> Yes, those are some really nice tax savings. So why does the US government allow it? Well, probably because the companies they get those tax savings, take some of those tax savings, and donate them to Senators and Congressman that in turn vote to keep LIFO on the books. Sorry, that was probably a bit too conspiratorial, so just ignore that prior comment. [LAUGH] But there is right now an act of discussion about whether companies should get this tax break. In fact, in the most recent budget proposed by the administration in the US, there's a proposal to eliminate LIFO as a way to raise additional taxes. Now there's heavy lobbying against that and the government here has seemed unable to pass a budget for years. We're sort of living off these continuing resolutions. But it is at least up for debate and it may be that at some point the US government also gets rid of LIFO. As a way to close this loophole and sort of take away this advantage of companies to earn significant tax savings. So now that I have just mentioned that the US government may get rid of LIFO as well. I should probably cut my losses and stop talking about it, given that it may go away within the next year or so. But anyway, that wraps up our look at inventory. All we have left for the week is our look at the 3M Company. 3M Company financial statements where we'll take a look at their accounts receivable and inventory. I'll see you then. >> See you next video.