The changing LIFO-FIFO dilemma and its importance to the analysis of financial statements.

Jesswein, Kurt R.

This paper examines how the probable demise of the LIFO inventory costing method will affect companies currently using LIFO as well as the financial analysis of those companies. Key financial ratios are examined along with how these ratios may be affected by the switch away from LIFO. A mixed bag of changes to key ratios, both improvements and deteriorations, are presented, along with a discussion of more complex topics for whom the impact of these changes are less clear.

INTRODUCTION AND BACKGROUND

Financial statements are the lifeblood of finance. Whether trying to evaluate a potential debt or equity investment or assess the creditworthiness of a potential borrower, the ability to properly analyze financial statements is crucial to the success of decision-making. One key element in this process is the determination and assessment of various financial and accounting ratios that allow one to better interpret the results of operations and the financial condition of the entity being evaluated. As this is almost wholly dependent on accounting numbers arising out of the accounting process, it is imperative that one understands the process and the reporting standards in place to guide such a process.

One important aspect of many-a-company's activities is the accumulation and subsequent sale of its inventory. Although there are many rules and guidelines in place governing the reporting of inventory, no other factor affects the analysis of financial statements greater than the method used to allocate costs between the units of inventory sold and those remaining unsold at the end of the reporting period.

For most entities, this decision comes down to one of three choices: the average cost method, the FIFO (first-in, first-out) method, and the LIFO (last-in, last out) method. Of particular interest are the polar extremes of FIFO and LIFO because the use of each causes the greatest differences in various figures reported on the balance sheet and income statement, and, ultimately, the financial ratios based on those figures.

The FIFO method assumes that the costs associated with the inventory that has been on hand the longest are the ones that are matched against the revenues generated from selling the inventory in the current period. Typically, in times of rising prices, the result is a lower amount assigned to the cost of goods sold on the income statement and a higher amount allocated to the valuation of the unsold inventory. Conversely, the LIFO method instead matches the most recent costs of inventory against current revenues, resulting in a higher amount associated with the cost of goods sold and a lower amount going towards inventory on-hand.

The choice between the two is typically based on a comparison of the advantages from using LIFO with the disadvantages. One of the more persuasive arguments for using LIFO is that it better fulfills a key assumption in accounting of matching current expenses with current revenues. On the other hand the most pervasive reason for choosing LIFO is the resulting tax benefits and improved cash flow situation. The so-called "LIFO conformity rule" states that a firm choosing LIFO must do so for both financial accounting and tax purposes. Under the LIFO method, more costs are charged off against current revenues, resulting in a lowering of before-tax earnings as well as the amount of taxes paid. This reduction in taxes paid (perhaps it is more accurate to say the deferral of taxes paid) improves the current cash flow situation for the reporting entity.

The tax benefits associated with using the LIFO method must in turn be balanced against the other reality of reporting lower earnings. For example, reporting lower earnings may have negative repercussions in meeting various debt covenants as well as in the valuation of the company's common stock. Furthermore, the remaining inventory is reported at an understated value on the balance sheet. To lessen much of the uncertainty regarding this information, companies that use the LIFO method are required to report the extent to which their inventory is undervalued relative to using the FIFO (or average cost) methods; this valuation adjustment is typically referred to as the LIFO reserve account.

However, the crucial choice of inventory costing method will soon likely vanish. There has been a long-term effort under the auspices of the International Accounting Standards Board to harmonize global accounting standards so that a single set of international financial reporting standards (IFRS) could be used anywhere. The Securities and Exchange Commission (SEC) has recently proposed that U.S. firms will have the opportunity to switch from U.S. generally accepted accounting principles to the new IFRS beginning in 2010 and would be required to do so by 2014. One important aspect of this change is the elimination of the use of the LIFO method because the IFRS simply does not allow it. This will likely have a dramatic impact on companies that currently use LIFO. This paper examines how this change in reporting standard would likely affect the financial statements of companies using LIFO and, more importantly, the analysis of those statements.

INVENTORY COSTING METHODS AND FINANCIAL STATEMENTS

The choice of inventory costing method effects a company's financial statements in a variety of ways. On the balance sheet, the use of the LIFO method tends to understate the value of a company's inventory. Consequently, it also understates the amount of current assets, as well as total assets, of the company. This ultimately will affect any ratio calculation involving inventory (e.g., days' sales in inventory), current assets (e.g., current ratio), or total assets (e.g., return on assets).

On the income statement, the use of the LIFO method typically overstates the cost of goods sold and thus understates gross profits, operating profits, and net profits. In turn, any ratio involving profit figures will be affected. However, there is one important exception. Occasionally, companies will sell sufficient inventory so that not only do current-cost inventory items get matched against the revenues, but also earlier layers of older costs and the value of the resulting LIFO reserve account is reduced. This leads to the understating of the cost of goods sold and an overstating of reported profits.

In any case, analyzing financial statements for companies using the LIFO method has always been difficult, particularly if comparisons are made with companies using the FIFO method. With the probable elimination of LIFO, this analytical problem will be minimized in the future. However, the elimination of LIFO can profoundly affect the analysis of companies currently using the LIFO method. Some of these potential effects are examined here.

DATA AND METHODOLOGY

All financial statement data were gathered from Compustat based on the data that was current through January 30, 2009. Relevant figures from the balance sheet and income statement were taken from the most recent annual reports as well as the three years prior. Several traditional financial ratios (the current ratio and quick ratios, days' sales in inventory, debt and debt-equity ratios, return on assets, and Altman Z-score) were then calculated based on the equations summarized below.

Exhibit 1

Calculation of Financial Ratios

Current ratio = Current assets / Current liabilities

Quick ratio = (Current assets = Inventory) / Current liabilities

Days' sales in inventory = Inventory / Daily cost of goods sold
[COGS/365]

Debt ratio = Total liabilities / Total assets

Debt-equity ratio = Total liabilities / Total common equity

Return on assets = Net income / Average total assets

Altman Z-score = 1.2[X.sub.1] + 1.4[X.sub.2] + 3.3[X.sub.3] +
0.6[X.sub.4] + 0.999[X.sub.5], where [X.sub.1] is defined as net
working capital (current asset--current liabilities) divided by total
assets, [X.sub.2] as retained earnings divided by total assets,
[X.sub.3] as earnings before interest and taxes divided by total
assets, [X.sub.4] as market value of the company's equity to the
book value of its liabilities, and [X.sub.5] as sales divided by total
assets

Free cash flow (as taken from and defined by Compustat) = Net cash
flows from operations less cash dividends and less capital investment

The current and quick ratios, as well as the days' sales in inventory, are commonly used ratios to evaluate a company's short-term liquidity. Higher current and quick ratios all typically associated with greater amounts of liquidity, as is a lower amount of days' sales in inventory. The debt and debt-equity ratio are used to assess the overall amount of external financing used to support a company's operations. Higher amounts, particularly when they become extreme, are typically viewed more negatively than smaller amounts. The return on assets is one of the more common measures of the profitability of the company's operations with higher amounts unsurprisingly viewed as more desirable. The Altman Z-score is a common metric used to assess a company's creditworthiness. An overall score of 3.0 is typically considered a minimum threshold below which the likelihood of default or of bankruptcy would become a serious concern. Because the score itself includes a wide variety of ratios, it was included to assess the potential impact on the change in credit standing of companies if they are no longer able to use the LIFO method. Likewise, many valuation models use the free cash flows generated by a company in evaluating a company's stock so these amounts were examined to assess the potential impact on the change in the valuation of the stock of companies using the LIFO method.

After calculating the various ratios based on the reported results found in the companies' financial statements, they were recalculated under the assumption that the LIFO method was no longer allowed. Ratio involving inventory, current assets or total assets was adjusted to include the value of the LIFO reserve account for that period. Note that the liabilities of the company would also be affected as the underreported profits from using the LIFO method would now be reported, creating an immediate tax liability. Current tax regulations allow for the payment of this liability to be spread over four years (Bloom, 48). Thus, for purposed of this study, twenty-five percent of the newly-created tax liability is allocated to current liabilities (due within one year) and the remaining amount to noncurrent liabilities. The equity (retained earnings) of the company would subsequently be affected by the resulting difference between the adjustment made to assets and made to the liabilities.

Ratios involving before-tax income statement items (e.g., cost of goods sold, earnings before interest and taxes) were adjusted to account for any positive or negative increments in the cost of goods sold. If the LIFO reserve account increased (decreased) during a particular time period, the assumption was that the cost of goods sold was overstated (understated) by that amount and adjusted accordingly. After-tax figures (e.g., net income) were adjusted to also remove the tax expense associated with the increase or decrease in cost of goods sold. For simplicity, a marginal tax rate of thirty-five percent was assumed in each case to eliminate the impact of other items (e.g., capital gains and losses and tax loss carryforwards) in the calculation of individual company's effective-tax rates for any given period.

OVERALL RESULTS

From the Compustat database we found that 385 companies were listed as using the LIFO method. However, only 333 of these actually reported a LIFO reserve account balance. Further reductions in the database (e.g., companies that did not report a stock price or another relevant variable such as current assets) resulted in a final sample size of 262 companies. The sample ranged in size from some of the largest and best-known companies in the world (ExxonMobil, Dow Chemical) to others with scarcely $10 million in total assets. Although heavily concentrated in specific industries (e.g., energy and minerals), companies using the LIFO method were found across a wide spectrum of industries and included companies as distinct as Walgreens, Colgate-Palmolive, Harley-Davidson, and Whirlpool.

As seen below in Exhibit 2, the use of the LIFO method can have a significant effect on various financial ratios. Depending on the extent to which LIFO had understated inventory and overstated cost of goods as well as other company-specific factors, we find a wide range of changes to many of the ratios. For example, the median days' sales in inventory figure increases by over thirteen days, a twenty percent increase over the current median of 63.7 days. This is not necessarily surprising given the extent to which the inventories are understated and to a lesser degree the extent to which cost of goods sold may have been overstated.

Other ratios did not demonstrate as large of a change but may be equally important. Adding the LIFO reserve amount to the reported inventory figure and the related tax liability to current liabilities has the effect of increasing the current ratio (by almost four percent on average), yet also reducing the quick ratio. This apparent disparity occurs because inventory is included in the current ratio but not the quick ratio (affecting the numerator of each ratio differently), but the current tax liability increases the amount of current liabilities and thus affects the denominator of both ratios equally.

On the other hand the debt and debt-equity ratios both decrease, which makes the average company appear less leveraged. This is not surprising, given that, except for companies with extremely low amounts of debt, the adjustments to the denominator (total assets and equity, respectively), are proportionately larger than the adjustments to the numerator (total liabilities).

Similar comments can be made about the average increase in the return on assets. Although the denominator (average total assets) is typically increased, often by large amounts because of the nominal size of the LIFO reserve account, net income typically rises as well, and proportionately in greater amounts, particularly when the LIFO reserve account increases substantially in any given time period.

The average Altman Z-score fell by approximately one percent. Although it would appear that the ratio should fall with the inclusion of the LIFO reserve in the total asset figure that appears in the denominator of four of the five variables, this effect is offset in large degree by increases in working capital, earnings before interest and taxes, and retained earnings that make up three of the numerators.

One component of the Z-score, however, is more difficult to assess, that being the ratio of market value of equity to book value of liabilities. The market value of a company's equity could be positively affected by the higher reported profits but more likely will be negatively affected by the reduction in cash flows from the company having to make higher tax payments. We found that the median amount of free cash flows fell by over seven percent. Simple common stock valuation models would thus forecast a reduction in a company's stock price by at least seven percent; and likely significantly more. This point will be examined in more detail later.

COMPANY-SPECFIC RESULTS

The changes in the ratios highlighted above are by no means consistent across the board. In fact, the possible impact from the elimination of the LIFO method on individual companies can be almost grotesquely affected. To examine this, we select three random case histories to demonstrate how differently the changes may affect individual companies.

We begin by examining ConocoPhillips, one of the largest companies in the world. Over the past three years, Conoco has expanded in size from $107 billion in total assets to nearly $178 billion. During this period, the reported value of its total inventories went from $3.7 billion, up to $5.2 billion, and then more recently back down to $4.2 billion. At the same time, the value of its LIFO reserve moved from $4.7 billion, down to $4.2 billion, and then jumped up to $6.7 billion. Conoco represents a classic case of the typical effects on key financial ratios. A summary of the results for Conoco is found below in Exhibit 3.

If not for using LIFO, Conoco would have reported a much higher current ratio. Likewise, days' sales in inventory would have more than doubled in length to almost thirty days. Its return on assets would have been more than twelve percent higher. On the other hand, we also find at least one of the problems that can occur in cases where the value of the LIFO reserve falls, as it did for Conoco two years ago. The dual components of having net income overstated and total assets (because of the inventory) understated combine to produce an actual return on assets figure that is more than twelve percent less than the one based on the reported results.

We next move to Central Steel & Wire. Over the past three years, the size of CS&W has remained relatively stable, beginning with $299 million in total assets two years ago, growing to $307 million the subsequent year, and then shrinking to $272 million last year. However, the size of its inventory did not follow the same pattern, as it moved from $73 million to $58 million and then to $64 million. Even more remarkable is the extent to which the LIFO reserve valuation dwarfed the actual value of the inventory, as it shifted from $141 million to $134 million and finally ending at $167 million. A summary of the results for CS&W is found below in Exhibit 4.

With CS&W we find many of the same changes as we found with Conoco. However, given how much larger the LIFO reserve account is relative to the size of the company, the changes are more profound. We have a current ratio increasing by more than fifty percent and a quick ratio falling by more than seventeen percent. The days' sales in inventory amount almost triples, adding nearly 100 days to the reported amount. The debt and debt-equity ratios also fall precipitously. The Altman Z-score falls an entire point. Although still well above the 3.00 threshold, the reduction from 5.43 to 4.42 would likely not be seen in a very favorable light. Nor would the elimination of the reported free cash flows. For example, CS&W would likely not have had sufficient free cash flows to cover the additional taxes that would have been due had the LIFO method been eliminated. Lastly, as with Conoco, we find the conflicting impact on return on assets due to increases and decreases to the LIFO reserve account. Two years ago, in a period with the LIFO reserve account fell, the return on assets figure would have been cut in half had the LIFO method not been used. The following year, when the LIFO reserve increased, we find that the reported losses would have been all but eliminated and the significantly negative return on assets reduced to essentially nil.

Lastly, we move to Hancock Fabrics, a smaller company that shrank during this period from $242 million to $151 million in total assets. Its inventory, which makes up an extremely very large percentage of its total assets, unsurprisingly followed the same pattern, falling from $192 million to $114 million. On the other hand, the LIFO reserve valuation remained relatively constant over this period, beginning at $39 million, and then moving up to $42 million before declining last year to $36 million. A summary of the results for Hancock is found below in Exhibit 5.

Again, we find many of the same results as with both Conoco and CS&W, the only differences being a matter of degree. However, perhaps more noteworthy, is the impact on the Altman Z-score. Based on its reported results we find its Altman Z-score from last year would have been a sold, but not stellar, 3.28. But after making the adjustments associated with eliminating LIFO, we find this number fall to 2.94, below the "magic" 3.00 threshold. And this does not include any adjustment to the stock price (and value of its common equity) that might result from the reduction in its cash flows associated with having to pay additional taxes!

SUMMARY AND CONCLUSIONS

Many companies (albeit a declining amount) have enjoyed the ability to reduce or delay payments for taxes on profits through their use of the LIFO inventory costing method. However, with the impending disallowance of the use of the LIFO method under International Financial Reporting Standards, these companies face a situation where their balance sheets and income statements (and cash flow statements) face significant changes. The analysis and interpretation of these financial statements also face an uncertain future.

We have shown that many of the key financial ratios used in business can be severely affected by a switch from the LIFO method. Balance sheets will likely be larger and income statements will report higher earnings. Liquidity ratios (particularly the quick ratio and days' sales in inventory) will largely suffer while leverage ratios (e.g., debt and debt-equity ratios) will likely improve. Profitability ratios (e.g., return on assets) will typically improve although they may also deteriorate depending on the relative impact of changing costs and the growth or shrinkage of inventories.

More complex ratios can be affected in a variety of ways. For example, although the Altman Z-score can be negatively affected by larger amounts of assets and liabilities, it is also positively affected by increased amounts of working capital and retained earnings as well as higher reported earnings. What is unknown is the possible influence on stock prices. It is conceivable that if the elimination of the LIFO method results in lower cash flows, the value of a company's stock will be negatively affected. Many valuation models are in large part driven by estimates of cash flows. If cash flows fall by seven percent, which was the average amount shown in this study, stock prices could fall by some seven percent using a very conservative no-growth perpetuity model. And if a company would be expected to have increases in future cash flows the impact on its stock price could be significantly higher.

As with other studies of this type, many liberties had to be taken regarding assumptions. For example, we have assumed that the companies using the LIFO method would have operated in the same way with the same results as if they did not have the ability to use LIFO. Nonetheless, the impending demise of the LIFO method as an inventory valuation option will likely have a significant effect on companies that employ the technique. The analysis of these companies will also be affected, particularly in terms of trend analysis, as analysts will need to restate past financial statements in ways similar to those described here prior to make any long-term assessments of these companies. We await this major shift in the accounting landscape with baited breath.

REFERENCES

Bloom, R. & W.J. Cenker (2009). The Death of LIFO? Journal of Accountancy. (207:1 (January), 44-49.

Comiskey, E.E., C.W. Mulford & J. Thomason (2008). The Potential Consequences of the Elimination of LIFO as a Part of IFRS Convergence. Working Paper, Georgia Tech Financial Analysis Lab. Retrieved February 2, 2009 at http://mgt.gatech.edu/fac_research/centers_initiatives/finlab/ finlab_files/ga_tech_cf_lifo_2008.pdf www.mgt.gatech.edu/finlab.

Federal Register (2008). Roadmap for the Potential Use of Financial Statements Prepared in Accordance With International Financial Reporting Standards by U.S. Issuers. Volume 73, Number 226 (Friday, November 21), 70816-56.

Kieso, D.E., J.J. Weygandt & T.D. Warfield (2007). Intermediate Accounting, Twelfth Edition. New York: John Wiley & Sons.

Kurt R. Jesswein, Sam Houston State University

Exhibit 2: Selected Figures for Entire Sample: As-Reported and
Adjusted Values

 As-Reported Adjusted Percentage
 (Medians) (Medians) Change

Current Ratio 1.89 1.96 3.8%
Quick Ratio 1.10 1.09 -1.3%
Days' Sales in Inventory 63.66 76.75 20.5%
Debt Ratio 54.93% 54.52% -0.8%
Debt-Equity Ratio 117.43% 114.01% -2.9%
Return on Assets 4.01% 4.10% 2.3%
Altman Z-Score 3.63 3.59 -1.1%
Free cash flow $81.1 $75.3 -7.1%

Exhibit 3: Selected Figures for ConocoPhillips: As-Reported
and Adjusted Values

 As-Reported Adjusted Percentage
 Figures Figures Change

Current Ratio 0.92 1.14 24.3%
Quick Ratio 0.76 0.75 -2.1%
Days' Sales in Inventory 11.21 29.44 162.6%
Debt Ratio 49.94% 49.40% -1.1%
Debt-Equity Ratio 99.77% 97.63% -2.1%
Return on Assets 5.90% 6.63% 12.5%
Return on Assets (previous year) 2.68% 2.34% -12.6%
Altman Z-Score 2.73 2.76 1.0%
Free cash flow $11,891.0 $11,307.6 -4.9%

Exhibit 4: Selected Figures for Central Steel & Wire: As-Reported
and Adjusted Values

 As-Reported Adjusted Percentage
 Figures Figures Change

Current Ratio 2.87 4.34 51.2%
Quick Ratio 1.95 1.62 -17.2%
Days' Sales in Inventory 35.35 133.23 276.8%
Debt Ratio 44.76% 41.05% -8.3%
Debt-Equity Ratio 81.01% 69.63% -14.0%
Return on Assets -7.57% -0.21% -97.3%
Return on Assets (previous year) 8.32% 4.75% -42.9%
Altman Z-Score 5.43 4.42 -18.6%
Free cash flow $11.8 ($2.8) -123.5%

Exhibit 5: Selected Figures for Hancock Fabrics: As-Reported
and Adjusted Values

 As-Reported Adjusted Percentage
 Figures Figures Change

Current Ratio 2.63 3.34 27.3%
Quick Ratio 0.46 0.42 -8.1%
Days' Sales in Inventory 180.42 256.10 41.9%
Debt Ratio 82.08% 72.93% -11.1%
Debt-Equity Ratio 457.83% 269.38% -41.2%
Return on Assets 18.36% 13.55% -26.2%
Return on Assets (previous year) -4.29% -2.97% 30.9%
Altman Z-Score 3.28 2.94 -10.2%
Free cash flow (24.3) (27.5) 13.1%