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Inventories - LIFO liquidation actually increases LIFO reserves (examples)

Hey guys, I am struggling a bit with how LIFO liquidation causes LIFO reserve to DECREASE. (as per answer to practice question 7 in Inventory section). I can show two example where LIFO reserve increases due to LIFO liquidation (selling more than buying/producing)

Consider the following example:

Two companies start with inventories containing 2 units of cost $1 per unit and 2 units of cost $2 per unit (both have inv of $6). I will write this as 1,1,2,2. 

Then they both sell a unit:

Inventories become 1,1,2 for LIFO and 1,2,2 for FIFO (LIFO reserve = 1)

They both buy a unit for $3:

Inventories are 1,1,2,3 for LIFO and 1,2,2,3 for FIFO

They both sell two units:

Inventories are 1,1 for LIFO and 2,3 for FIFO (LIFO reserve = 3)

The LIFO reserve has clearly increased under LIFO liquidation (it went from 1 to 3). I have triple checked my maths and im pretty sure im not making any errors. Is the rule only defined for certain values or something?

Another example - two companies have inventories with three units of a good with costs 3,3,3 and 4,4,4  (Lifo and Fifo respectively) [LIFO reserve = 12 - 9 = 3]

They both buy one unit for 10:

3,3,3,10 and 4,4,4,10

They both sell 2 units, and are left with:

3,3 LIFO inv, 4,10 FIFO inv. [LIFO reserve = 14 - 6 = 8]

The LIFO reserve increases again, this time from 3 to 8. Am I doing something wrong?

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Hello,

I know it’s been a while since this was posted, but I’m currently preparing for L1 and I found myself having the same question as yours.

I read on the Schweser that “if a firm is liquidating its inventory, or if prices are falling, the LIFO reserve WILL decline”, and that “a LIFO liquidation occurs when a LIFO firm’s inventory quantities decline.”

But I found it implausible even with a very simple counter-example (similar to the ones you mentioned) as:

LIFO: 1 2 3 –> 1 2 –> 1 2 4 –> 1

FIFO: 1 2 3 –> 2 3 –> 2 3 4 –> 4

Starting with the same inventory, after selling one, buying one, and then again selling two, we have LIFO reserve going from 0 to 2 to 3, indeed increasing.

I wonder if you have worked this out eventually, and would like to share your thoughts, or if anyone else is willing to help. That’d be very helpful to me.

My personal guess is that Schweser is wrong on this part, as I couldn’t find such statement on the curriculum that says a LIFO liquidation WILL decrease LIFO reserve.

Thanks.

Hi, hyl0327

Go back to LIFO liquidation definition it is in the curriculum for sure (red flags for accounting section).  When you liquidate cheaper inventory you boost your earnings and thus LIFO reserve must decline (you utilize or put in use a cheaper layer of COGS).  When prices are falling difference between FIFO na LIFO inventory decreases  or if you sell more than you produce/buy.  

For companies using LIFO inventory, they can get an artificial boost to earnings by running the inventory balance low at year-end. It is clearly a red flag, you can identified it  by reviewing the footnotes for a decline in the LIFO reserve…

regards

R

Hi, rafal,

Thank you for you reply. I almost thought nobody’s going to answer this.

Regarding your answer, I can appreciate that if there’s a decline in LIFO reserve, then by definition there’s a LIFO liquidation (assuming inflation). What I cannot appreciate is the other way around, that LIFO liquidation always RESULTS IN a decline in LIFO reserve.

As given in my last reply, this counter-example shows a case where LIFO liquidation doesn’t lead to a decline in LIFO reserve:

LIFO: 1 2 3 –> 1 2 –> 1 2 4 –> 1

FIFO: 1 2 3 –> 2 3 –> 2 3 4 –> 4

Starting with the same inventory, after selling one, buying one, and then again selling two (hereby making a LIFO liquidation), we have LIFO reserve going from 0 to 2 to 3, indeed increasing.

I know that this is kind of a special case, as I found that in most cases LIFO liquidation actually decreases LIFO reserve. I was just being a bit pedantic and was wondering if this is valid in EVERY case. If that’s true, then there must be something wrong with the construction of the above counter-example, and would you mind pointing it out, please?

Anyway, thank you for your help, and I look forward to your next reply.

Ah, and I forgot this one.

You mentioned: ”When you liquidate cheaper inventory you boost your earnings and thus LIFO reserve must decline (you utilize or put in use a cheaper layer of COGS).”

When you say you’re “boosting” something, it must be compared to a benchmark. In this case, I think the benchmark is “the earnings if we didn’t liquidate cheaper inventory (we bought or produced more inventory)”, but not “the earnings if we were using FIFO instead of LIFO”. Therefore, I don’t think this necessarily have anything to do with LIFO reserve.

This is also mentioned in Schweser: “A LIFO liquidation occurs when a LIFO firm’s inventory quantities decline. Older, lower costs are included in COGS COMPARED TO a situation in which inventory quantities are not declining. LIFO liquidation results in higher profit margins and higher income taxes COMPARED TO what they would be if inventory quantities were not declining.”

You’re simplifying too much already obvious things or overdoing…

you subtract LIFO reserve from LIFO cogs ( inflated COGS in rising prices environment) to adjust earnings fo FIFO. of course you are boosting earnings iteration #1  LIFO COGS= 3 and FIFO COGS =1 FIFO is boosted too. Benchmark can be profitability under current price environment of course 

It is the math and flaws in simplification in your calculation.In your example prices have risen significantly from 1 to  4 though which translates to  300% increase…a hyperinflation by definition ( Zimbabwe has it on monthly basis today). What if you sell all at the end?

  hope this helps 

           beg               sell three   buy three  sell three or even all

LIFO: 1 2 2 3 3 –> 1 2 –> 1 2 3 3 3 –> 1  or 0

FIFO: 1 2 2 3 3 –> 3 3 –> 3 3 3 3 3 –>  3  or 0

  LR is respectively 0 3 2 or 0

rafal wrote:

It is the math and flaws in simplification in your calculation.In your example prices have risen significantly from 1 to  4 though which translates to  300% increase…a hyperinflation by definition ( Zimbabwe has it on monthly basis today). What if you sell all at the end?

  hope this helps 

           beg               sell three   buy three  sell three or even all

LIFO: 1 2 2 3 3 –> 1 2 –> 1 2 3 3 3 –> 1  or 0

FIFO: 1 2 2 3 3 –> 3 3 –> 3 3 3 3 3 –>  3  or 0

  LR is respectively 0 3 2 or 0

Well, I did mention that I agree that LIFO liquidation WILL IN MOST CASES lead to a decline in LIFO reserve (assuming inflation).

I was just trying to disprove the statement that LIFO liquidation WILL lead to a decline in LIFO reserve (assuming inflation), as given in the SchweserNotes.

So long as I can give a counter-example where this doesn’t happen, no matter how simplified, how imaginary, or how exaggerating it may be, I can disprove the word “WILL”, right?

Thanks.