Question

Inventories valued on the LIFO basis at December 31, 2016 and 2015 were approximately $47.5 million and $51.8 million, respectively, less than the amounts of such inventories valued at current costs.  As a result of reducing certain inventory quantities valued on the LIFO basis, net income (after tax) increased by $2.2 million, $1.8 million, and $1.3 million in 2016, 2015, and 2014, respectively.

a. By how much would net income (after taxes) have differed for 2016 if Varscom had used FIFO method for valuation of inventory items, instead of LIFO?  Assume a 40% marginal tax rate.  Be sure to indicate whether FIFO income would be higher or lower than LIFO income.  (Hint: By definition, difference between LIFO inventory and current cost inventory is LIFO reserve)

b. What would the LIFO reserve have been on December 31, 2016 if no LIFO liquidation had occurred in 2016? (Hint: without LIFO liquidation, LIFO reserve does not reflect the pretax profit from the liquidation of LIFO layer)

c. What would motivate Varscom management decide to liquidate the LIFO inventory layer?  

Answer 1

a) The inventories valued on the LIFO basis is always less than the inventories valued at current costs as due to inflationary trend in the economy the purchases price keeps on increasing over the period. Thus, the company provides for such difference in inventory costs which is called as LIFO reserve. It can also be interpreted as higher purchase costs of such inventory is expensed in the income statement and, therefore a LIFO reserve is created as a measure to account for such unrealised gains.

In FIFO system of valuation of inventory, such LIFO reserve would be the actual income of the compamy. Thus, $47.5 million the LIFO reserve balance as on December 31, 2016 would be additional taxable profits. The additional net income (after tax) is $28.5 million after providing for 40% marginal tax rate respectively.

We conclude that the FIFO income would be higher than LIFO income whenever a LIFO reserve exists.

b) If no LIFO liquidation had occured in 2016 then the LIFO reserve balance would have been $51.8 million as on December 31, 2016 respectively. The colsing balance of the year ended 2015 which is $51.8 million would continue to remain, had no LIFO liquidation occurs during the year 2016.

c) A complete liquidation of LIFO inventory layer is not recomended to Varscom management as it will result in tax liabilities. However, a certain portion of LIFO reserve must be credited to income statement for next few years based on the inventory holdings on the company.