Partners: Yizhen Dong and Francisco Vazquez
Dow Chemical Company Inventories
Attached are the excerpts from Dow Chemical’s Annual report for 2012. Based on the information in the financial statements and footnotes, please, answer the questions below. Assume a tax rate of 35%.
1. Dow Chemical used LIFO, FIFO and average cost to value its inventories. In December 31, 2012, the value of inventories at LIFO is US$2,458M.
2. The book value of inventories at Dec. 31, 2012 using FIFO would be higher than the amount currently reported, because all the old, lower cost, units are already sold. It differs by LIFO reserve = US$842M.
Total stockholders’ equity at Dec. 31, 2012 using FIFO would be higher than the amount currently recorded.
Assuming tax rate of 35%, shareholders equity would be higher by LIFO reserve * (1-tax rate) = US$547m
Income before taxes at Dec. 31, 2012 using FIFO would decrease by US$263M. ΔLIFO reserve = US$-263M
Using FIFO for all costs, 2012FY COGS would be 47,792 +ΔLIFO reserve = US$48,055m.
3. Dow Chemical saved income taxes cumulatively over the years since inception by using LIFO to record part of its inventory. LIFO reserve * Tax = Cumulative Taxes postponed by LIFO = 842 * 35% = US$294.7m.
By using LIFO in 2012FY, Dow Chemical did not save tax, instead they paid more taxes. This is because the LIFO reserve went down, mostly likely due to their procurement costs lowering.ΔLIFO reserve 35% = US$-92m. They paid US$92m more tax than they would using FIFO.
If I were CFO of Dow and the LIFO conformity rule had been repealed by Congress and assuming that I believe in the concept of stable inflation growth over time and do not foresee and disruptions in the supply chain of my raw materials, I would use:
1) For financial statements: I believe that the answer depends on the strategic position then company wants to adopt:
By adopting FIFO, operating margins and income will be higher. Your assets (inventory) will also be higher on the B/S. By adopting LIFO, assets base and income will be lower, but there would be significant postponing of taxes and would be able to discretionarily manage LIFO reserve during inflationary period to boost net income in those years.
2) LIFO inventory for tax reporting purposes - as shown in previous exercise, allows postponement in taxes since inception of the company
4. Physical inventory levels in 2012FY decreased because LIFO reserve decreased by US$263m. The decision to reduce certain inventories from Dow Chemical might be interest to give a more positive signal to investors in terms of income, optimization of physical inventories need (hydrocarbon and US chemicals and plastics product inventories), adjustment of procurement amount due to changes in prices of raw material and price of final product (changes in margin).
5 If Dow Chemical has no inventory left at the end of NEXT year (fiscal year 2013):
Inv FIFO = Inv LIFO => LIFO Reserve = 0
=> Cumulative COGS LIFO = Cumulative COGS FIFO
=> Cumulative NI LIFO = Cumulative NI FIFO
=> Cumulative SE LIFO = Cumulative SE FIFO
Hence as retained earnings is cumulative, it will be the same for FIFO and LIFO. The answer would not change if purchase price of inventories are expected to increase by approximately 50% in 2013.
6. Potential disadvantages of LIFO include inflating COGS, reducing operating income and taxes paid during increasing purchasing costs. This also allows a company to discretionary manipulate B/S and I/S during times of inflating / deflating procurement costs and also is less transparent when comparing companies that adopt different policies in the same industry.
Delta and Singapore Airlines
Prior to July 1986
Between July 1, 1986 to March 31, 1993
After April 1, 1993 10 year to 10% residual
15 year to 10% residual
20 year to 5% residual
Annual depreciation (per $100 gross equipment)
Prior to April 1, 1989
Post April 1, 1989 8