CFA level 1 : FRA : LIFO reserve

mehak.officiallink
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CFA level 1 : FRA : LIFO reserve

Postby mehak.officiallink » Wed Nov 12, 2014 3:28 pm

What is a LIFO reserve ?
If
Current asset is $10 million
Current liab is $ 5 million
Lifo reserve 2013 $ 500000
Lifo reserve 2014 $ 700000

Why is lifo reserve of 2014 added to current asset to determine the adjusted current ratio ?
Why is the difference between 2 year change in lifo subtracted from the cost of goods sold?

Please discuss the logic indicating what does a lifo reserve and changes in it indicate ???

edupristine
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CFA level 1 : FRA : LIFO reserve

Postby edupristine » Thu Nov 13, 2014 6:20 am

The LIFO reserve is the difference between the accounting cost of an inventory that is calculated using the FIFO method, and one using the LIFO method.

In the typical inflationary environment, the value of a FIFO inventory is higher than the value of a LIFO inventory, so the calculation of the LIFO reserve is:

LIFO Reserve = FIFO Valuation - LIFO Valuation

Since the reason for valuing an inventory using LIFO is usually to defer the payment of income taxes, the LIFO reserve essentially represents the amount by which an entity's taxable income has been deferred by using the LIFO method.

The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFOsince the time that LIFO was adopted. The change in the balance during the current year represents the current year's inflation in costs.

The change in the balance in the LIFO reserve will also increase the current year's cost of goods sold. That in turn reduces the company's profits and taxable income. The change in the balance of the LIFO reserve during the current year multiplied by the income tax rate reveals the difference in the income tax for the year. (Thebalance in the LIFO reserve times the income tax rate reveals the difference in income tax since LIFO was adopted.)

The disclosure of the LIFO reserve allows you to better compare the profits and ratios of a company using LIFO with the profits and ratios of a company using FIFO.

edupristine
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CFA level 1 : FRA : LIFO reserve

Postby edupristine » Thu Nov 13, 2014 6:30 am

When dealing with valuing a company using ratios, one must also convert all numbers to FIFO method for easy comparison.

This means that, for example, when calculating the current ratio, the LIFO reserve should be added back into the numerator of the equation.

Using the LIFO reserve adjustment, the current ratio = (current assets + lifo reserve)/ current liabilities

edupristine
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CFA level 1 : FRA : LIFO reserve

Postby edupristine » Thu Nov 13, 2014 6:32 am

The difference between 2 year change in LIFO should be subtracted from COGS to get the value of FIFO COGS


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