I am working on a traditional cash flow for a car dealership (net income + depreciation + interest) based off of corporate tax return information. They use the LIFO method to value inventory. The accountant is telling me that I need to add the “LIFO Reserve” figure back to the traditional cash flow to get a correct cash flow. Can you give me some details on the LIFO reserve and why it is/isn’t correct to add it back?
- FIFO: First-in-first-out inventory method assuming inventory sold is the first inventory purchased or manufactured.
- LIFO: Last-in-first-out inventory method assuming inventory sold is the most recent purchased or manufactured.
- LIFO Reserves: The difference between inventory based on the FIFO method and LIFO method from the day the company started using LIFO.
I do not agree with your borrower’s accountant….
LIFO Reserves do not relate solely to the current year. Thus they should not be added back to current year cashflow. Besides, LIFO uses as an expense the most recent purchases. The most recent purchases probably more accurately reflect the current impact on cashflow of purchasing inventory. Another reason not to add the LIFO reserves, or even this year’s changes in LIFO reserves, back for cashflow purposes.
You also asked: Can you give me some details on the LIFO reserve and why it is/isn’t correct to add it back, etc. Also, what impact does the LIFO reserve have on the income statement and the balance sheet?
So here is a bit more on the inventory methods, LIFO reserves and what difference it makes. Some of this will be review and some of it may be more than you ever wanted to know. I encourage you to read the entire explanation anyway because as a business lender, the more you understand about business and about financial statements, the better resource you can be to business owners and the better decision-maker you can be for your lending institution.
Why use a model for inventory…can’t we just keep track of what we sell?
Unless a business has discreet items to sell, it must find an easier way to account for inventory than keeping track of each specific item sold. An small antique store can keep track of each item. A clothing store cannot. There are several methods to use, and the ones impacting the LIFO reserves are FIFO and LIFO. Here are your definitions.
FIFO Inventory method assumes that the first inventory purchased (the oldest in stock) is sold. In times of rising prices, it will result in a higher (and perhaps more accurate) ending inventory on the balance sheet (most recent purchases) and a lower cost of goods sold on the income statement (using earliest less costly purchases). A lower cost of goods sold will result in a higher net income. Thus in a time of rising prices, a company using FIFO will pay more taxes (not good for them) but will show better financial results to investors and lenders (good for them).
Proponents of FIFO for financial statement purposes contend that it better represents the ‘value’ of the inventory, since it is based on more recent purchases.
LIFO Inventory method assumes that the last inventory purchased (the most recent) is sold. In times of rising prices, it will result in a lower ending inventory on the balance sheet (the earliest less costly purchases) and a higher cost of goods sold on the income statement (using the costlier most recent purchases). The financial statements will show lower net income which does not look as good to investors and lenders.
With a higher cost of goods sold, though, taxable income will be lower and the company will pay less taxes. Some would say this is tax deferral, because eventually the rest of the inventory (earlier purchases) will be sold. Others would say it is a permanent tax break, since it is unlikely a going concern will dip all the way back into the lowest levels of inventory.
LIFO Reserves is the amount by which a company’s inventory account balance calculated under FIFO would exceed its inventory account balance calculated under LIFO for the same physical inventory. The Ending LIFO Reserve represents how many fewer dollars LIFO has capitalized in inventory and hence how many more dollars LIFO has expensed in Cost of Goods Sold as compared to FIFO since the firm has been using LIFO. The Ending LIFO Reserve represents the cumulative effect of using LIFO versus FIFO.
The SEC requires that all registered companies using LIFO report their LIFO reserves for the start and end of the year. Therefore, one can always convert a LIFO firm to FIFO. This is important if you are trying to compare one company to another when one uses FIFO and the other LIFO.
On the financial statements:
LIFO Reserves may be indicated in the notes to the financial statements. They may also be shown on the balance sheet as a ‘contra’ (negative) inventory account and reflects the difference between FIFO and LIFO inventory amounts since the inception of the LIFO inventory method. In that case the inventory is shown based on FIFO, then adjusted by the LIFO reserve to the LIFO-based amount.
The idea of adding back the LIFO reserves does not work because it is the cumulative impact of the difference in the two methods since LIFO was adopted. One could argue that there should be an add-back for just the difference in the reserve for the two years, but I disagree there as well. That assumes that FIFO is the best approximation of cash-flow. My sense is that LIFO actually is, since it shows COGS based on the most current purchases.
The change in the LIFO Reserves from one year to the next indicates that year’s difference. It will be an increase in years of rising prices if all the inventory sold was purchased during the period. It can be a decrease either in periods of dropping prices for inventory or if the inventory sold this period was greater than purchases, and therefore ‘dipped’ into pools of lower priced inventory.
I checked with a very experienced commercial lender for his take. He said:
“I go through the financials very thoroughly when dealing with the auto industry, especially car dealerships. If I need the LIFO reserves to make a deal work, I step back and try to look at it from a broad perspective: is this a good thing? I generally like the deal to work without it, and show it both ways. Depending on their volume, how big is the figure? How does it look every year? Generally, auto dealers don’t have cars more than a year or two. While I try to understand what they are doing with the figures (whether it be to show a lower number for tax reporting but a higher number for investors and bankers), I don’t add it back for ‘cash flow’.”