Why LIFO higher cash flow?

Sorry if this sounds ignorant, but I often hear LIFO results in higher cash flow. Why is this? I know taxes are lower but so is net income, which flows into the cash flow statement. Don't they counteract each other so the answer should depend on the degree of which taxes and net income decrease by? thanks.

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Comments (37)

May 20, 2009 - 7:42pm

If you make the assumption that the inventory has a higher cost associated with it using the LIFO method, then you will show a lower inventory number at the end of the period compared to if you had used another method. Since you will have a greater decrease in inventory, it will be a greater source of cash compared to using another method

May 20, 2009 - 8:59pm

tax is a cash expense while depreciation is not a cash expense. When you take your net income into your statement of cash flows you adjust for non-cash expenses.

Think about it this way, you are going to have to physically write a check for the tax, while how you depreciate your inventory isn't going to affect your bank account.

However, do keep in mind that tax accounting and financial accounting are very different and tax accounting has pretty standard depreciation formulas (generally a double decline).

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May 20, 2009 - 11:32pm
eric809e:
tax is a cash expense while depreciation is not a cash expense. When you take your net income into your statement of cash flows you adjust for non-cash expenses.

Think about it this way, you are going to have to physically write a check for the tax, while how you depreciate your inventory isn't going to affect your bank account.

However, do keep in mind that tax accounting and financial accounting are very different and tax accounting has pretty standard depreciation formulas (generally a double decline).

Exactly. You have to ADD back depreciation expense to the statement of cash flows because it does not affect cash. (assuming the indirect method)

May 21, 2009 - 12:29am

I think where I'm confused is where the depreciation comes in. You don't depreciate inventory right? I only see 2 factors here: the decreased net income due to COGS and the decreased tax as a result. Ending inventory I agree is lower, but how does that affect cash?

May 21, 2009 - 1:11am

Why when someone here asks something about cash flow impact you guys only know to talk about the depreciation expense???

The guy is asking something about the Inventory method (LIFO/FIFO) and some people here don't have a clue of what he's talking about and keep posting crap as if they were in an interview.... come on guys!

To sum up all the crap these people posted here, goalieman688 has it right!

Your inventory balance on BS is going to be lower (assuming a rising inventory cost - that's what generally happens) and therefore this works as a "source" of cash (decline in an asset account on BS) and not a use of cash (increase in a BS account), resulting in a higher operating cash flow.

Simply that! It has nothing to do with depreciation, etc...

To all other members in THIS POST: Stop regurgitating things you read in these interview guides!!!
This strategy is not gonna fly when you start your internship...

May 21, 2009 - 1:06am

Ok... here it goes a detailed example:

  1. Decrease Inventory by $3, let's say;
  2. Increase COGS by $3
  3. Net Income will decrease by (-$3 * 35%) = -$1.95
  4. Cash Flow from Ops. decreases by $1.95 (Net Income was reduced)
  5. However, cash flow from ops. increases by $3 due to adjustment in inventory (a reduction), a working capital item
  6. Net result in the cash flow from Ops is: -$1.95 + $3.0 = $1.05 (increase)

So, cash flow from ops. has increased $3.0, due to lesser working capital requirement (since inventory was reduced - LIFO) - positive impact on CF.

On the other hand, net income was reduced due to higher COGS (net of tax at 35%) - negative impact on cash flow of $1.95.

Net effect on cah from ops. = $1.05

Forget about depreciation that has nothing to do with that. As I said in my earlier post, some members just regurgitate interview guides in here.

That's all you've got to know!

Hope that helps!

May 21, 2009 - 6:50am
lui:
Ok... here it goes a detailed example:
  1. Decrease Inventory by $3, let's say;
  2. Increase COGS by $3
  3. Net Income will decrease by (-$3 * 35%) = -$1.95
  4. Cash Flow from Ops. decreases by $1.95 (Net Income was reduced)
  5. However, cash flow from ops. increases by $3 due to adjustment in inventory (a reduction), a working capital item
  6. Net result in the cash flow from Ops is: -$1.95 + $3.0 = $1.05 (increase)

So, cash flow from ops. has increased $3.0, due to lesser working capital requirement (since inventory was reduced - LIFO) - positive impact on CF.

On the other hand, net income was reduced due to higher COGS (net of tax at 35%) - negative impact on cash flow of $1.95.

Net effect on cah from ops. = $1.05

Forget about depreciation that has nothing to do with that. As I said in my earlier post, some members just regurgitate interview guides in here.

That's all you've got to know!

Hope that helps!

Thanks - this makes perfect sense now. Also appreciated the other responses.

Stk123 - honestly did not see your name before I created mine. I've used this user name for a long time - even my email address is this. Gotta say I was slightly amused when I saw your post.

May 21, 2009 - 1:25am
stk1234:
Sorry if this sounds ignorant, but I often hear LIFO results in higher cash flow. Why is this? I know taxes are lower but so is net income, which flows into the cash flow statement. Don't they counteract each other so the answer should depend on the degree of which taxes and net income decrease by? thanks.

Seriously dude, you could have been at least a little bit more original with your name choice. Please change it immediately, because people here will start confusing your posts with mine, and you are already giving me a bad rep by asking these idiotic easy ass questions. On top of that you still don't understand why cash flow is higher using LIFO (assuming inflationary periods) even though a few posters answered your question correctly(although there are several idiotic answers in this thread as well).

I will explain it to you:

Lets forget about taxes for a minute and lets assume that Company X does a thousand transactions throughout the year, which results in company x having $$$ of cash on hand. Now no matter what accounting principles you use (LIFO, FIFO, HC, FMV, LCM, straight-line, MACRS etc.), you will still have $$$ the same amount of cash at the end of the year. The only difference is what you will see on your books (different accounting methods will give you different results on your income statement, B/S).

Now taxes come into play: Since you are using LIFO your pre-tax income will be lower when compared to FIFO, which means that you will be paying lower taxes (giving away less cash) to the IRS. Giving away less cash (out of $$$) means that you will end up with more cash on your balance sheet, and therefore higher cashflow.

May 21, 2009 - 11:13am

The only time time that depreciation would have an effect on your cash flow statement is if you over or understated the depreciation number or a capital expenditure number in which the asset was depreciated in that year...

May 21, 2009 - 11:31am
goalieman688:
The only time time that depreciation would have an effect on your cash flow statement is if you over or understated the depreciation number or a capital expenditure number in which the asset was depreciated in that year...

That is incorrect: it doesn't matter if you depreciated every single asset to $0 or didn't take any depreciation at all. At the end of the day depreciation is a non-cash item and you still have the same amount of cash on hand, which is reflected in your cash flow statement.

If you make an error when recording depreciation, that depr. expense flows through all of the financial statements and has no net effect on cash flow; it will only affect your Net Income and Total Assets on the B/S.

The difference between inventory methods and depreciation methods for tax purposes is that different inventory methods are also used for tax purposes and therefore affect your cash flow (different tax liabilities using different methods). Whereas it doesn't matter how you depreciate assets on your books, you are still obliged by the IRS to use MACRS for tax purposes and will always get the same result, and therefore IN REALITY depreciation does not effect your cash flows.

May 21, 2009 - 11:44am

Understand the matching principal which is required under US GAAP so when your realizing revenue you have to expense your inventory your cost of goods sold which is realizing the newer costs in a inflationary price environment under Lifo. Thus COGS will be higher relative to Fifo. Now trickle this down through the line items. you will realize less operating income, which leads to less taxable income therefor you will have a higher cash flow from operations because you have less income to be taxed. Net income will be lower under lifo than fifo in an inflationary pricing environment. Hope this helps.

Depreciation will never effect cash flows because this is a non cash item and statement of CF works on a cash basis.

May 21, 2009 - 12:14pm
dipset1011:

Depreciation will never effect cash flows because this is a non cash item and statement of CF works on a cash basis.

Your explanation was of LIFO/cash flows was correct (basically restated what others already said), but this quote that I outlined does not make sense. Although you are correct that depreciation is a non-cash item, but using LIFO or FIFO is also a non-cash item (you still pay the same amount of cash for inventory independent of the method uses).

As I explained in my previous post, the difference in inventory methods and depreciation methods is that when you use LIFO you use that same method for tax purposes, and if you use FIFO, you also use it for tax purposes. These two methods will result in different tax liabilities owed to the IRS, i.e. different cash flows.

Now whether you use Straight-line or double-declining depreciation for book purposes, you have to use MACRS for tax purposes and will always have the same tax liability no matter what method you use.

Therefore, depreciation does not effect cash flows not because it is a non-cash item (as you stated), but rather because the depreciation method used for tax purposes is always the same.

May 21, 2009 - 12:52pm

Dude if you are talking about deferred tax assets and deffered tax liabilities it does not pertain to inventory. Inventory is realized at lower of cost or market hence if you write down your inventory it will be realized as a write down in continuing operations as a gain or loss (Gain pending if you sold it or not). Inventory is not depreciated Non current assets such as PPE are. Cost of goods sold is on the cashflows statement because it is a CASH OUTFLOW! sure the methodology for recognizing prices are different under fifo or lifo but either way it is still a CASH OUTFLOW ITEM! stop bringing in the tax code because the only relevance is that under LIFO you will have Higher CFO due to less Taxes being paid (in inflationary periods). Depreciation has nothing to with what the OP was asking.

May 22, 2009 - 11:41am

Hey dipset, you have no clue what you are talking about. I will not comment on your retarded statements, because I already explained once why your statement was incorrect and you still don't get it because you are simply too dumb. You are just babbling over there and are completely wrong about what you are saying.

I have a masters degree in accounting and have worked for two different CPA firms, and know a lot more about accounting than you will ever know.

" stop bringing in the tax code because the only relevance is that under LIFO you will have Higher CFO due to less Taxes being paid (in inflationary periods)."

I brought in the tax code, because it is what causes a difference in cash flows while using LIFO vs. FIFO etc (and doesn't cause any differences when switching between depreciation methods). But you don't understand this because you don't understand how a business model works and how information actually flows through the financial statements in the real world. All you know is what you read (or didn't read) in a book, while in school.

So please stop trying to correct me, because you have no clue what you are talking about. Now go back to school and pay attention in class and you may actually learn something.

May 21, 2009 - 4:06pm

Lol hey bud i am not the one who is mentioning depreciation when the kid was asking why LIFO has higher CFO. Good to hear you have a masterss in accounting though that certainly did you no good considering the fact that i have never taken an accounting class. You should probably go kill yourself now. I learned more accounting through my training of two weeks relative to your miserable 1-2 year stint of studying. You should read my reasoning by the way i think most would agree that i am right and well....your comments are just bland and treads off to tax codes........have fun working at H&R block

I am completely aware of what causes DTL and DTA, differences between taxable income and pre tax income/tax expense and taxes payable and how it ultamatley effects CFO...depreciation is a non cash charge! that gets added back to net income under the indirect method to arrive at CFO.....you are just an idiot because the kid wanted to know a simple concept not the tax code. Hence why i stepped in to clear things up a little bit.

May 21, 2009 - 4:29pm
dipset1011:

you are just an idiot because the kid wanted to know a simple concept not the tax code. Hence why i stepped in to clear things up a little bit.

You are the idiot, because you did not clear anything up but rather caused more confusion with the misleading and incorrect answer that you gave. The tax code is the answer to his question, and I already explained (twice) why. Most people on this board (like yourself) do not truly understand this concept; and I gave him an exact answer that is the only complete answer in this thread.

May 21, 2009 - 3:59pm

I brought in depreciation, because first golieman 688 and then YOU (dipset) each made a comment about depreciation and I corrected you both, because both of your reasonings were incorrect.

...and I did read your reasoning and it makes no sense and you are wrong. If you don't understand my previous explanation then it is because you have no clue how information flows in the accounting system of a business.

dipset1011:
Cost of goods sold is on the cashflows statement because it is a CASH OUTFLOW! sure the methodology for recognizing prices are different under fifo or lifo but either way it is still a CASH OUTFLOW ITEM!"

And here is one of many areas where you are wrong; COGS is NOT a cash flow item, but rather an accounting item. COGS are recorded when you record a sale (no cash outflow here). The statement of cash flows is a reconciliation of a companies cash position at a point in time, and how you record COGS on your books doesn't affect your cash position (outside of taxes). And the only reason that LIFO (as compared to FIFO) increases your cash flow is because of taxes - the IRS allows you to use the same method for inventory for tax purposes as it does for book.

When it comes to depreciation (for PP&E) it is also an accounting item (just like LIFO and FIFO), but does not affect your cash flows because of the way the tax code is constructed (always use MACRS for tax purposes). If the IRS were to let you use the same depreciation method for tax as you used for book purposes (just like when accounting for inventory), then it would affect your cash flows just like a switch from LIFO to FIFO.

dipset1011:
Understand the matching principal which is required under US GAAP so when your realizing revenue you have to expense your inventory your cost of goods sold which is realizing the newer costs in a inflationary price environment under Lifo. Thus COGS will be higher relative to Fifo. Now trickle this down through the line items. you will realize less operating income, which leads to less taxable income therefor you will have a higher cash flow from operations because you have less income to be taxed. Net income will be lower under lifo than fifo in an inflationary pricing environment. Hope this helps.

Depreciation will never effect cash flows because this is a non cash item and statement of CF works on a cash basis.

I already told you that your first paragraph is a good explanation to the OPs question, but the last sentence that you wrote is incorrect and I explained why you are wrong and you still don't get it. Hopefully this time you will understand. And please stop correcting me because you have a very limited understanding of financial statements and you clearly don't know what you are talking about.

May 21, 2009 - 4:26pm

Fifo and Lifo are pricing methodologies for ending inventory and COGS for the income statement and BS. I was wrong by mentioning that it was CF item on the CF Statement i dont know where my head was at and i am sorry for the harsh statements. I guess i got a little heated because you mentioned (MACRS) an IRS depreciation method which the OP probably has no idea what it is. Also the CFO act's on a cash basis so is objective atleast more so than the income statment where accounting methodologies come into play like you said. Anyways i am sorry for my rant and have a nice day.

May 21, 2009 - 4:48pm

You say: "Fifo and Lifo are pricing methodologies for ending inventory and COGS for the income statement and BS."

in that case: Straight-line and double-declining methods are pricing methodologies for ending Fixed Assets and Depreciation expense for the BS and IS, respectively. See the similarities between COGS and Depreciation here?

but you say that: "COGS are cashflow items and affect cash flows, while depreciation expense is a non-cash item and doesn't affect cash flows."

You see how wrong you are? And everything I wrote about taxes was to explain why you were wrong. I hope you understand now.

If you walk into a bank with this know-it-all attitude (when you don't know shit) you will be the first to get canned. You need to learn to admit to mistakes, because you are not that smart and you will learn that really quick at a real job if you ever get an offer.

Now have a good day!

May 21, 2009 - 10:27pm

O.P: please refer to my previous post on why LIFO delivers higher cash flow, and ignore the crap this guy (stk123) is posting here.

stk123: too much here my friend! The kid asked something very, very simple that was priviously answered by a bunch of members including me.

And you, acting like an ACCOUNTANT, have this terrible habit of complicating things. Yes, COGS does affect cash flow indirectly, because any entry in the Inventory account is reflected in COGS and vice-versa, so indirectly it will appear in any variance of the Inventory ending balance in the CFO.

And bear in mind we are bankers, so we don't care about the month-end financial closing process that accountants deal with (by the way, that is shit!). We touch the numbers after you have finished it and do some "adjustments" on a pro-forma basis when appropriate - like this case with LIFO/FIFO - specially for projection and consistency purposes (when spreading comps for retail companies, for example).

I'm with dipset on this one. And that's it!!! Shut your fucking mouth up!

May 21, 2009 - 11:27pm

Everyone needs to take a step back and chill out.

There is no need to swear to put people down with offensive language. There are a lot of helpful responses here. The immature attitude is what scares off seasoned professionals because they don't want to deal with any of this attitude.

Lui - stk123 is being helpful and I don't think he is over complicating things at all. The tax advantage IS the answer to why there is cash. Interviews are looking to see that you understand how the statements intercorrelate rather than just spewing off formulas.

The changing valuation value on the balance sheet does not generate cash. In your example, the $1.05 created is SOLELY the result of decreased tax payable from a higher expense of writing down your inventory (depreciation may not be the correct word, but the expense will be in COGS or as a separate line item). Should the cash tax advantage be eliminated (in the case of adjusting valuation methods for financial reporting and not tax reporting) the actual effect on cash flow is zero.

In summary:
1) Changing valuation methods to reduce your inventory will increase your expenses on your books (but not affect cash)
2) A lower earnings before taxes should lead to a lower tax expense, and lower your tax payable account
3) Less tax payable = more cash flow

The actual valuation of the inventory will not affect cash flow. The gain you see on the cash flow is simply offsetting a reduction in your net income (through COGS or a separate line item)

May 21, 2009 - 11:45pm

Hey lui, I don't understand your aggression towards me, but since you are such an asshole all I can say to you is that you need to shut your mouth. This is your response that you gave the OP in your previous post:

"Your inventory balance on BS is going to be lower (assuming a rising inventory cost - that's what generally happens) and therefore this works as a "source" of cash (decline in an asset account on BS) and not a use of cash (increase in a BS account), resulting in a higher operating cash flow."

This answer is wrong, you don't understand how information flows through the financial statements either. Are you sure that you work in banking? If you gave this answer in a banking interview you could kiss your chances of landing an offer goodbye.

Although a decrease in inventory is a source of cash, you forgot something very important here, specifically that the "source" of cash is offset by lower net income which is a use of cash. And the only reason that you get higher cash flow using LIFO is because you save on taxes, which is what I was explaining.

I don't understand why you are criticizing me for my answers, since I am the only one that gave a complete and correct answer to the OPs question.

You lui should have stayed out of this. First you go bashing everyone else that they're giving dumb answers, while you give a wrong answer yourself. Shut up yourself, because you don't know what you are talking about.

edit: Thanks Eric for your support, I was just trying to give the OP a complete answer and correct other misleading/wrong answers. You are right: there is no need for vulgarity.

May 22, 2009 - 4:34am

stk123: you just said what I had already said before in my detailed example. Review it and then you'll see that I was saying exactly the same thing.

In my example, I went step-by-step describing what happens in each statement (so, I think I quite understand the relationship between the 3).

I clearly state that COGS increases, Net income decreases (outlining the tax effect at a 35% tax rate), Inventory on BS decreases. And the net result of all that, is an increase of $1.05 captured in the CFO (-$1.95 NI + $3.00 inventory decrease), that's exactly the tax saving effect.

Review it first, and then come to me and point out specifically where I was wrong.

May 22, 2009 - 10:10am

lui: this is the answer that you gave the OP in your first post, and it is the one that I commented on, and IT IS WRONG.

lui:
Why when someone here asks something about cash flow impact you guys only know to talk about the depreciation expense???

The guy is asking something about the Inventory method (LIFO/FIFO) and some people here don't have a clue of what he's talking about and keep posting crap as if they were in an interview.... come on guys!

To sum up all the crap these people posted here, goalieman688 has it right!

Your inventory balance on BS is going to be lower (assuming a rising inventory cost - that's what generally happens) and therefore this works as a "source" of cash (decline in an asset account on BS) and not a use of cash (increase in a BS account), resulting in a higher operating cash flow.

Simply that! It has nothing to do with depreciation, etc...

To all other members in THIS POST: Stop regurgitating things you read in these interview guides!!!
This strategy is not gonna fly when you start your internship...

I guess that you realized that you were wrong (maybe after reading erics post about taxes), and then corrected it in your next post.

lui:
Ok... here it goes a detailed example:
  1. Decrease Inventory by $3, let's say;
  2. Increase COGS by $3
  3. Net Income will decrease by (-$3 * 35%) = -$1.95
  4. Cash Flow from Ops. decreases by $1.95 (Net Income was reduced)
  5. However, cash flow from ops. increases by $3 due to adjustment in inventory (a reduction), a working capital item
  6. Net result in the cash flow from Ops is: -$1.95 + $3.0 = $1.05 (increase)

So, cash flow from ops. has increased $3.0, due to lesser working capital requirement (since inventory was reduced - LIFO) - positive impact on CF.

On the other hand, net income was reduced due to higher COGS (net of tax at 35%) - negative impact on cash flow of $1.95.

Net effect on cah from ops. = $1.05

Forget about depreciation that has nothing to do with that. As I said in my earlier post, some members just regurgitate interview guides in here.

That's all you've got to know!

Hope that helps!

This explanation is correct, but it only works because the tax code allows you use the same inventory method on your tax return as you use on your books.

Now if I asked you what would happen to cash flow if a company goes from straight-line depreciation to an accelerated method, you would probably give me the same answer:

"that depreciation expense increases, Net income decreases (outlining the tax effect at a 35% tax rate), fixed assets on BS decreases. And the net result of all that, is an increase of $1.05 captured in the CFO/CFI (-$1.95 NI + $3.00 Fixed Asset decrease), that's exactly the tax saving effect."

Very similar example, but this answer would be WRONG because of the TAX CODE!!! The IRS forces you to use MACRS for tax purposes no matter what you use for books (unlike inventory). So in this case the company would have made an entry on its books to record a deferred tax asset (DTA)= $1.05, which would mean that there would have been no change in Cash Flows (increase in DTA of $1.05 is a "use" of cash on the CFO).

Now I know the OP asked about LIFO, but Dipset made a dumb comment on Depreciation that was incorrect, because he had no clue what he was talking about, and I corrected him so others like the OP don't give a wrong answer in a potential interview.

Dipset wrote "Depreciation will never effect cash flows because this is a non cash item and statement of CF works on a cash basis."

...while claiming that COGS is a "cash flow item". But in reality both COGS and Depreciation are very alike, and when I corrected him, he would come up with an even dumber answer instead of admitting his mistake.

I can't understand how you can disagree with me if you claim to understand this topic, everything that I wrote is correct. And if you stand by dipset's side, well then you don't really understand it.

May 22, 2009 - 10:56am

Stk is right in terms of cogs and depreciation being slightly alike. It's pretty intuitive and management bias. Its pricing methods to realize what costs are going on the income statement. Hence you can use fifo, lifo, and Weighted average to price your cogs and for depraciation you can use SL,DDB and estimates of salvage value and usful life to price(expense) your depreciation on the income statement which will all inherently effect your bottom line net income.

Methods of depreication causes timing differences between the tax code and income statement hence causes a deferred tax liability. Again per the tax code they use MACRS which is an accelarated method relative to say SL on the income statement. Since there is more being depreciated per the tax code you have less taxes payble due to less taxable income and are incurring the expense now rather than the future. Same thing goes for warranty/allowance/writeoffs which cause DTA. Where you are incurring the expense now per the income statement but tax code will not realize this until its actually proven that these items are uncollectible or write off will be realized for certain gain or loss on sale hence these items are not deductable till the future when they are realized. Therefor less tax payable in the future.

what really hurts is that you called me dipshit which was completely uncalled for dude. Seriously man how old are 5? I couldn't sleep last night becuase of this.

May 22, 2009 - 10:50am

Funny, I paused for smoke while studying for CFA, and came to dig what was going on on WSO. I seems I can't run away from FIFO's and LIFO's!!!

For the OP, I'll quote a paragraph from the CFA curriculum that nicely explains this issue:

"In an environment of rising inventory unit costs (...) LIFO will allocate a greater amount of cost flow to cost of goods sold on the income statement and a lesser ammount of cost flow to the carrying value of inventory on BS. Accordingly,(...) a company's gross profit, operating profit and income before taxes will be lower. Income tax expense will thus be lower under LIFO, causing the company's net operating cash flow to increase. On teh BS, a lower inventory carrying value will also cause reported working capital and total assets to be lower."

See, easy as that. Come on guys, no need to unsheath your swords for each misunderstanding that arises...

May 22, 2009 - 11:11am

Alright guys, I think we were all heated with this topic.

But at the same time, we ended up with a very constructive technical discussion.

I got your point stk123, and I do agree that the tax issue is the key point in this discussion (in both the inventory and depreciation matters). Although I don't think you can assume that if asked about depr. I would give the same answer, since I know that book and tax depr. creates timing differences that are reflected in deferred taxes.
I answered ONLY about inventory, that was the original question (in my answers I did not mention anything about depr.)

Just one last thing: in your last post, you mentioned MACRS vs. straight line creates DTA, don't you think you are wrong and that it creates a DTL, as outlined by dipset above??

May 22, 2009 - 11:55am

Sorry about that Dipset (i edited that post). It was uncalled for, but I wrote that because I got offended by your post in which you tried explaning to me that we depreciate fixed assets and not inventory (I thought this was obvious when I was writing my post, but I understand that you could have understood differently since only I know what my thoughts were in my head when I was typing it).

Anyway lui, what I meant with the DTA is that if a company switched from straight-line to an accelerated depreciation method on its books it would increase the amount of DTA that company records on its books (or lower the amount of DTL, which is the same thing just depends whether the co. has a net DTA or net DTL balance on the B/S).

But yeah, you are right that MACRS vs. straight-line causes a DTL (like dipset wrote), but I was talking about something different, specifically a change from S-L to accelerated depreciation.

May 22, 2009 - 12:16pm

No worrys im just joking anyways, i got a question though so when i said depreciation would not effect the statement of cash flows you stated that I was wrong. The statement of CF works cash basis cash inflows and cash outflows from operating/investing/financing. Is the reason why you disagree with my statment is because the tax expense (cash outflow from operations) can be manipulated due to DTA/DTL? Thanks for clearing this up for me by the way.

May 22, 2009 - 8:30pm

dipset, I was just basically disagreeing with you, because you said the LIFO will cause higher cash flows (correct), but that depreciation will never affect cash flows because it is a non-cash item. When in actuality both LIFO (or COGS) and depreciation are non- cash items and work in a similar way. Let me explain with an example.

Company X earns $100 operating profit (10% tax rate to keep it simple). They use straight-line depreciation and book $10 of depr., but for tax purposes MACRS depr = $30. So

Book Net Income 100-10=90(1-.10)=$81 after $9 tax expense (book #)
Taxable income 100-30=70
10%=$7 actually paid in taxes. And you would book a $2 DTL (30-10)*10%=2

So your Cash flow statement is:

NI $81
+depr 10
+DTL 2

CFs= $93, which is your ending cash balance

Now if you used an accelerated depreciation (instead of straight-line) method for books, lets say depr. expense = $20.

Book Net Income 100-20=80(1-.10)=$72 after $8 tax expense (book #)
Taxable income 100-30=70
10%=$7 actually paid in taxes. And you would book a $1 DTL (30-20)*10%=1

So your Cash flow statement is:

NI $72
+depr 20
+DTL 1

CFs= $93, which is the same ending cash balance as if you used straight-line depreciation.

The difference with inventory is that the IRS doesn't have a MACRS equivalent for inventory, because it would be too difficult and cumbersome for companies to convert their ending inventory numbers to a different method. The IRS forces the companies to use the same method for taxes as the company uses for book purposes. That is why LIFO results in higher cash flows and different depreciation methods don't (no deferred taxes here). If the IRS forced all companies to use LIFO (for example) for tax purposes, then you wouldn't have any difference in cash flows whether you used FIFO or LIFO (and there would be DTAs/DTLs for inventory).

IMPORTANT NOTE: If anyone gets a depreciation question like this during an interview, then be careful what you say. If you don't understand deferred taxes then you may not want to give them my answer. And most likely you will get a question asking what will happen if the company takes an additional $10 in depreciation? Depending on what "additional" means it is probably safe to say that it will decrease net income, tax expense, and therefore increase your cash flow (which would be true only if the company also took an additional $10 of depreciation for tax purposes).

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