Explain LIFO Reserve and LIFO Liquidation

US GAAP requires companies which 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,

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 based on the LIFO method, to the FIFO 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 the 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, and a company which 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 have been rising and LIFO liquidation occurs, an inventory-related increase in gross profits will be produced. 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?

A. If inventory unit costs are rising and LIFO liquidation occurs, an inventory-related decrease in gross profits will occur.

B. The LIFO reserve is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported under FIFO.

C. A decline in the LIFO reserve from the prior period may indicate that LIFO liquidation has not occurred.

Solution

The correct answer is B.

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

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

Question 2

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

A. None, as LIFO is a pure accounting choice that has no implications on the statement of cash flow

B. The operating cash flow section

C. The financing cash flow section

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 affects the operating cash flow.

Reading 25 LOS 25e:

Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios



Isha Shahid
Isha Shahid
2020-11-21
Literally the best youtube teacher out there. I prefer taking his lectures than my own course lecturer cause he explains with such clarity and simplicity.
Artur Stypułkowski
Artur Stypułkowski
2020-11-06
Excellent quality, free materials. Great work!
Ahmad S. Hilal
Ahmad S. Hilal
2020-11-03
One of the best FRM material provider. Very helpful chapters explanations on youtube by professor James Forjan.
Rodolfo Blasser
Rodolfo Blasser
2020-10-15
The content is masters degree-level, very well explained and for sure a valuable resource for every finance professional that aims to have a deep understanding of quantitative methods.
Mirah R
Mirah R
2020-10-15
Great course! Very helpful
Priyanka
Priyanka
2020-09-29
Analyst Prep has actually been my soul guide towards this journey of FRM.I really appreciate the videos ad they are ALIGNED , good speed, and the Professor just keeps everything Super CASUAL. If I Clear my exams Ultimately credit goes to you guys. Keep sharing. God bless.
Sar Dino
Sar Dino
2020-09-29
Had a test on actuarial science coming up and was dead on all the concepts (had to start from ground zero). came across the channel as it had small bits of FM chapters consolidated by the professor Stephen paris. this made it easy for me to look at the chapters i was having trouble with (basically everything lol). I love the way he explains the questions, and the visualization! its so helpful for me to see the diagrams and how the formulas move around. he really did a great job explaining, and i understand so much better. 7 weeks worth of lessons condensed into 3 days of binge watching their videos.... Amazing and i am truly baffled as to why the videos have not gained traction as they should have!

Share:


Related Posts

Accounting Equations

Financial statement elements (assets, liabilities, owners’ equity, revenue and expenses) are used as...

Measurement Bases – Assets and Liabilities

Financial assets are measured and reported at either fair value or amortized cost....