Convert a Company’s Reported Financial Statements from LIFO to FIFO

It is oftentimes necessary to compare the financial statements of companies that use LIFO to those of their counterparts that use FIFO. The use of the LIFO reserve makes this possible.  For example, the LIFO reserve disclosure enables adjustments to be made to the financial statements of a US company that uses the LIFO method, thereby making it comparable to a similar company that uses the FIFO method.

Conversion of Reported Financial Statements from LIFO to FIFO

To compare companies that use the LIFO method with other companies, the inventory amount has to be adjusted by adding the disclosed LIFO reserve to the inventory balance that is reported on the balance sheet. The cost of sales figure should also be adjusted by subtracting the increase in the LIFO reserve during the period from the cost of sales amount reported on the income statement.

If the LIFO reserve decreases during a reporting period, the decrease in the reserve should be added to the cost of the sales amount which is reported on the income statement.

Question 1

If a company uses the LIFO method, in converting the reported inventory amount to FIFO, the company has to:

1. Add the disclosed LIFO reserve to the inventory balance.
2. Multiply the inventory balance by the disclosed LIFO reserve.
3. Subtract the disclosed LIFO reserve from the inventory balance.

Solution

The correct answer is A.

The inventory amount will have to be adjusted by adding the disclosed LIFO reserve to the inventory balance that is reported on the balance sheet.

Question 2

Xtractor Inc. uses LIFO to evaluate its inventory. The price of production inputs within the company’s industry has been decreasing for the last few years. To compare the gross profit of Xtractor with other companies reporting using FIFO, an analyst would need to:

1. Add the amount of increase of the LIFO reserve to the cost of goods sold.
2. Add the amount of decrease of the LIFO reserve to the cost of goods sold.
3. Subtract the amount of decrease of the LIFO reserve from the cost of goods sold.

Solution

The correct answer is B.

Since the prices of inventory have been decreasing, the LIFO reserve must have been decreasing as well. Further, since the company has been reporting a cost of sales lower than the actual replacement cost, due to price decreases, the company’s cost of sales has been underestimated. To make a proper estimation of Xtractor’s cost of sales, the amount of decrease of the LIFO reserve needs to be added to the cost of sales.