I’m struggling with LIFO liquidation and LIFO reserve. From what I can tell, LIFO liquidation is to due possibly to an increase in sales, but not being met by production (not enough product lines, not enough employees, etc.). How often does a LIFO liquidation happen where the COGS for LIFO is significantly lower, thus resulting in higher net income, etc.? Any help would be greatly appreciated?
Don’t think production, product lines, employees, etc. It’s all about the number and flow of physical units in ending inventory. Under LIFO, ending inventory consists of older items that have been on the balance sheet, valued at their original cost for years. Picture a barrel holding a bunch of …golf balls. As you sell them, you order more and top off the barrel. If in one year you end up selling more than you added in, you’ll end up digging down and selling some of the older golf balls that have been sitting near the bottom of the barrel for years. That’s what LIFO liquidation is. When your sales in terms of physical units exceeds your purchases during the year, you end up selling (and thus expensing in CGS) some old, lower cost (assuming times of rising prices) items that have been included in ending inventory in the past. Hope this makes sense.
That does make sense–maybe there should be a different term than LIFO liquidation…
i think it’s a good term. It’s LIFO because really it’s just accounting method, so you’re not really selling old golf balls. It’s just the cost you’re associating that ball with. And since you’re reducing your physical capital inventory to cash or recievables it is liquidation of that inventory.
I should add that LIFO and FIFO are “cost flow assumptions”, they don’t necessarily reflect the actual physical flow of goods. You could account for sales of cartons of milk using LIFO, which would assume that ending inventory consists of older cartons, when that is not the case.
Not to sound dumb, but why is LIFO liquidation so important? Does it help you uncover other issues that may be going on: lack of production, fewer purchases than sales, etc… Maybe I’m just making it harder than it should be.
In times of rising prices, with old layers of low value inventory, a LIFO liquidation will result in a CGS number that is low and unsustainable, producing income and operating margins that are not indicative of a company’s ongoing earnings ability, and make for poor peer nalysis and relative valuation.
It’s important b/c it’s an easy tool for manipulating COGS and therefore net earnings. More often it’s done purposefully by management to lower COGS rather than being a consequence of unexpectedly high sales or production problems. And if the current costs are much higher than the value of the old inventory, the net earnings are unrealistic and not sustainable in the long run.
Makes sense. I’ll re-read the section and see now if I can determine if it’s easy to recognize a LIFO liquidation (from the financial statements/footnotes); therefore, resulting in unsustainable margins/income…
Thank you all for your help, I really appreciate it!!!
Realistically the inventory accounting focus by CFAI is a little silly now-a-days. With the adoption of Just-in-Time inventory practices and relatively low inflation rates the differences in income from using LIFO or FIFO are relatively minor. I’m sure there are a few examples (or industries ) that may contest my statement, but in reality the over focus on some of the inventory accounting topics in Level I are fruitless to what analysts should be focusing on.
So I really shouldn’t focus too much of my efforts on Reading 35 (Analysis of Inventories) for Level I?
Char-Lee - I go back to the days of economic order quantity (EOQ) and safety stock inventory concepts. While JIT has helped reduce overall inventory levels, the fact that you see significant inventory amounts included on the balance sheets of many companies is clear evidence that this is still an issue of importance for analysts.
point taken Super I, although the lack of “material” inflation over the last 25yrs has helped to keep many inventory cost trends fairly level (obviously there are certain exceptions). It just seems that CFAI puts more emphasis on this topic then I believe necessary… mind you though I am only a lowly level I candidate, so what do I know.