Explain LIFO Reserve and LIFO Liquidation

US GAAP requires companies that use the LIFO method to disclose the amount of the LIFO reserve in the notes to the financial statements or on the balance sheet.

It is important to review disclosures on LIFO reserves to determine if LIFO liquidation has occurred. A decline in the LIFO reserve from a prior period may indicate that LIFO liquidation has occurred.

LIFO Reserve

LIFO reserve refers to the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used. In the form of an equation,

$$\text{LIFO Reserve = FIFO Inventory Value – LIFO Inventory Value}$$

Disclosure of the LIFO reserve equips analysts with the information needed to adjust a company’s cost of sales (or cost of goods sold) and ending inventory balance to the FIFO method based on the LIFO method.

During periods of rising inventory unit costs, inventory carrying amounts under the FIFO method will exceed inventory carrying amounts under the LIFO method. The LIFO reserve may also increase over time as a result of the increasing difference between the older costs that are used to value inventory under LIFO and the more current costs that are used to value inventory under FIFO.  Additionally, when the number of inventory units manufactured or purchased exceeds the number of units sold, the LIFO reserve may increase due to the addition of new LIFO layers.

LIFO Liquidation

Whenever the number of units that are sold exceeds the number of units that are purchased or manufactured during a period, the number of units in ending inventory will be lower than the number of units in beginning inventory. In such a circumstance, a company that uses the LIFO method is said to experience a LIFO liquidation wherein some of the older units held in inventory are assumed to have been sold.

If inventory unit costs rise and LIFO liquidation occurs, an inventory-related increase in gross profits will be realized. This increase in gross profits will occur because of the lower inventory carrying amounts of the liquidated units. The lower inventory carrying amounts are used for the cost of sales while the sales are reported at current prices. The gross profit on these units is higher than the gross profit that would be recognized using more current costs. These inventory-related profits caused by LIFO liquidation are however one-time events and are unsustainable.

During economic downturns, LIFO liquidation could result in higher gross profit than would otherwise be realized. If the LIFO layers of inventory are temporarily depleted and not replaced by the fiscal year-end, LIFO liquidation will occur resulting in unsustainable higher gross profits.

LIFO liquidation may also generate positive cash flow and result in higher taxable income and higher tax payments.

Question 1

Which of the following statements is correct?

1. A decline in the LIFO reserve from the prior period may indicate that LIFO liquidation has not occurred.
2. If inventory unit costs are rising and LIFO liquidation occurs, an inventory-related decrease in gross profits will occur.
3. The LIFO reserve is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported under FIFO.

Solution

The correct answer is C.

A is incorrect because a decline in the LIFO reserve from the prior period may indeed indicate that LIFO liquidation has occurred.

B is incorrect because if inventory unit costs rise and LIFO liquidation occurs, an inventory-related increase, and not decrease, in gross profits will occur.

Question 2

Which cash flow portion could be affected by the occurrence of a LIFO liquidation?

1. The financing cash flow section.
2. The operating cash flow section.
3. None, since LIFO is a pure accounting choice that has no implications on the statement of cash flow.

Solution

The correct answer is B.

Although the choice of LIFO over any other method does not affect the cash flow related to sales, it affects the cost of goods sold. The LIFO liquidation’s effect on the cost of goods sold would affect gross income, which affects income tax, which in turn affects the operating cash flow.