Well, the discussion of the LIFO reserve caused several people to ask me: What’s a LIFO reserve?
Spoiler alert: I’m going to give you the answer. But first I want to talk a little bit about accounting and how accounting relates to you as an investor.
To put it simply, understanding accounting is critically important to becoming a better investor. The following quote is only one example, but I have seen Buffett repeatedly talk about how incredibly important accounting is to any businessperson.
Jamie Kitano, a UC Davis joint MBA-Law student asked (Buffett) the first question:Put simply: Accounting is the language of business. If you don’t understand accounting, you can’t understand if businesses are performing well or poorly. And, if you don’t understand accounting, you are much, much more likely to invest in frauds. Ask yourself this: How has almost every major fraud been busted? From Enron to Allied Capital to Chinese reverse mergers, it’s been from investors spotting irregularities in their financial statements.
“What are MBA students today lacking? What do we need to do to raise the bar on our educations?”
Warren answered by saying what he thinks are the most critical skills that managers need today. First, everyone should have a good understanding of accounting. “Accounting is the language of business.” He said that he knew some very bright CEOs who faked it, but a thorough understanding of accounting measures and practices is critical to success. (Source)
So how do you get better at accounting?
I would recommend taking a beginning and introductory accounting course at a local college. Of course, that’s probably out of the question for most of you. But if any of you are going back to school to get an MBA, still in undergrad, or just have the opportunity to take a class — that’s what I’d recommend most highly.
Short of that, you could work through accounting texts and read accounting books. Here’s the accounting text I used in college (though I used an early edition). If memory serves me, I also came across this book in a more advanced accounting/finance class in college. Both are also highly rated from the grumpy old accountants. That post also recommends Financial Shenanigans as a good book for learning to uncover frauds, and I wholeheartedly agree.
Finally, you could work through the CFA program. I’ve taken (and passed!) levels 1 and 2 so far, and they’ll give you a nice buildup in accounting and corporate finance. Of course, they are expensive, time consuming, and teach a lot of things that are not relevant to investors, but they will definitely get you up to speed in accounting.
Okay, so those recommendations out of the way, let’s hit on the difference between LIFO and FIFO.
Businesses are constantly buying and selling inventory. However, it’s nearly impossible to track each individual inventory piece. Imagine a screw distributor that’s buying and selling millions of screws every week. It’s impossible for them to track which specific screw they sell in individual transactions. So companies come up with accounting systems to allocate costs to their sales.
LIFO and FIFO are two types of accounting systems. LIFO (last in, first out) means that a company assumes that when they sell a unit, they assume they sold the most recent unit they purchased. As an example, imagine the screw company mentioned above bought a screw one month ago for $1, then bought a screw yesterday for $2, and finally sells a screw today for $3. The company would assume the last screw they bought was the screw they sold. Thus, they’d book $3 of revenue, $2 of expenses, and $1 of profit. They’d also have an inventory balance of a $1 screw.
FIFO (first in, first out) means a company assumes that they sell whatever the oldest piece of inventory they have is. In the example above, the company would assume they sold the first piece of inventory they bought (the $1 screw), and would thus book $3 of revenue, $1 of expenses, $2 of profits, and have an inventory balance of a $2 screw.
Ignoring taxes (which we’ll hit in a second), the cash flow and economics of the business from both FIFO and LIFO are the same, but the profits and inventory booked will come out different!
Both systems have their benefits and drawbacks.
FIFO’s benefit is it more accurately matches how businesses try to run their inventory. Think of a grocery store: they make sure to put their oldest inventory at the front of the shelves. Businesses try to move their oldest inventory first, because that’s the most likely to get stale.
LIFO’s benefit is it actually lowers profits. First, let’s discuss why this is, and then we’ll discuss why it’s a good thing.
LIFO lowers profits because prices, in general, rise over time (if there was no change in pricing over time, there would be no difference between LIFO and FIFO). By assuming they sell the newest inventory first, businesses are assuming they are selling their highest cost inventory. Higher costs equal lower profits.
Why is lowering profits a good thing?
Because lower reported profits means lower taxes, which means the business can actually keep more of its cash!
That’s right: A business using LIFO will report lower taxes but generate more cash than the same company using FIFO!!!! Of course, LIFO has no reflection in business reality (I can’t think of a single business that actively tries to hold on to its older inventory while moving its new inventory!), and many international accounting standards don’t allow for LIFO.
So what is a LIFO reserve?
Companies that report in LIFO are required to show a reconciliation between what their reported inventory would be valued at under LIFO and what it would be under FIFO. So, by adding back the LIFO reserve, investors can see what a company would be reporting for their inventory value if they valued their inventory at more recent prices. Here’s the example from SCX’s balance sheet.
So, in this example, inventory balance would be approximately 50% higher if the company used FIFO instead of LIFO. It resulted in $1 million in higher costs in 2011 but (and this is something to watch out for, as discussed below) an $8.5 million decrease in costs in 2010.
Some things to watch out for: LIFO reserves won’t necessarily flow directly through to the bottom line. Remember, a company used LIFO to lower profits and lower taxes. Thus, if they were to completely eliminate that LIFO reserve, Uncle Sam will be there to take a piece of it.
Second, companies reporting LIFO liquidations (where they eat into that LIFO reserve, generally because the company is shrinking) will report artificially high profits as they sell low cost inventory. Beware, as often times a company reporting serious sales declines will have a LIFO liquidation that results in record reported profits as the company is falling apart!!!! While they didn’t report record results in 2010, SCX’s results would have been even worse if not for a bit of LIFO liquidation resulting in reduced costs (as seen above).
Similarly, in times of price deflation, LIFO results in lower expenses than FIFO. Again, just keep an eye on this — during bad economic times strange things can happen to reported profits. I saw several microcaps that reported in LIFO that had artificially high profits during 2009 because of price deflation, and you can see some this in SCX’s 2010 results discussed above.
Finally, I’ve heard absolute horror stories of companies switching from LIFO to FIFO to keep up a string of profit growth during the 1950s. At this point, I’m positive that U.S. companies have realized investors are wise to this game, and U.S. analysts are watching out for it — but I wouldn’t be surprised if some companies in emerging markets try to pull that trick at some point, or if an up and coming high flyer tries it. If you’re investing in foreign markets that allow for LIFO or high flying momentum stocks — beware!
So, to put it all together, I’m going to show you an inventory footnote that will (hopefully) sum all this up for you.
This is the footnote from a very, very illiquid microcap (so no, I can’t give you the name of the company — sorry!). But I think it really serves to break down the differences between FIFO and LIFO.
If you break down this footnote, You can see that inventory balances would have been markedly higher during both years if they had used FIFO instead of LIFO. Profits also would have been higher in 2010 if they had used FIFO. However, in 2009, they experienced price deflation, so their operating loss under LIFO was actually lower than it would have been under FIFO.
I hope this has served as a useful primer or refresher on the joys of LIFO accounting!