It is oftentimes necessary to compare the financial statements of companies which use LIFO against companies which use FIFO. 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 which uses the LIFO method, thereby making it comparable to a similar company which uses the FIFO method.
Conversion of Reported Financial Statements from LIFO to FIFO
In order to compare companies which 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 sales amount which is reported on the income statement.
If a company uses the LIFO method, in converting the reported inventory amount to FIFO, the company has to:
A. add the disclosed LIFO reserve to the inventory balance.
B. subtract the disclosed LIFO reserve from the inventory balance.
C. multiply the inventory balance by the disclosed LIFO reserve.
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.
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:
A. Add the amount of increase of the LIFO reserve to the cost of goods sold.
B. Add the amount of decrease of the LIFO reserve to the cost of goods sold.
C. Subtract the amount of decrease of the LIFO reserve to the cost of goods sold.
The correct answer is B.
As the prices of inventory have been decreasing, the LIFO reserve must have been decreasing as well. As 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.
Reading 27 LOS 27f:
Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison