Tuesday, 24 April 2012

Converting from LIFO to FIFO

I saw this question posted by someone on a forum.

Due to declining prices, Steffen Inc. has a LIFO reserve of –$20. Its income tax rate is 35%. If an analyst is converting Steffen’s financial statements to a FIFO basis, which of the following adjustments is most likely required?

Increase assets by $20.
Increase shareholders’ equity by $13.
Decrease liabilities by $7.

The interesting thing to note in this question was the negative LIFO Reserve. So far I have been dealing with questions which have positive LIFO Reserves through the ending was less in many instances but the Net value to be negative... I hadn't seen it before. 
When Financial Statements are converted from LIFO basis to FIFO basis there is an imbalance which occurs in the Balance Sheet Equation. As FIFO Inventory = LIFO Inventory + LIFO Reserves, changing the cost flow basis increases the inventory but in this case the LIFO Reserve is negative, the inventory would decrease so A is incorrect.
Since FIFO COGS are less (Under inflationary environment) Reducing them results in higher net profit margins after tax adjustments and so does Retained Earnings. Therefore they increase by the amount = LIFO Reserves x (1-tax rate). In this it is clearly written that the environment is deflationary so converting to FIFO basis the Retained Earnings will increase by -20 x (1-35%) = -13$, effectively decreasing, so B is Incorrect.
Apparently the answer should be C as both A & B have been concluded as wrong. To balance the accounting equation, Liabilities must decrease by amount 20 x tax rate = 7$ as Assets are decreasing by $20, Equity is decreasing by $13 therefore Liabilities must decrease by $7 so C is Correct.
Okay but which liability is gonna decrease? Now this is interesting. I think that deferred tax liabilities accounts for the differences between tax payable and the tax actually paid. If tax payable is higher under some transaction taking place today but not paid then a liability is recorded which will be settled in the future. We know that under LIFO companies report less taxes as LIFO COGS are higher. Changing the cost flow basis to FIFO results in higher tax payable amount and if it is not paid in cash then a liability, deferred tax, is created. However in this case as the LIFO Reserves have become negative, the Deferred tax liability will decrease. The option that any other asset will increase is not provided and apparently the liability which should reduce seems to be Deferred Tax. 

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