I can’t understand why are the prices ‘out of date’? According to me, the prices in LIFO are recent/latest prices and hence the COGS shall be overstated! Please help Under last in first out (LIFO) accounting during periods of inflation, when a firm sells a greater quantity of its inventory than it produces or acquires, the result is: A) lower earnings. B) an understatement of the cost of goods sold (COGS). C) an increase in the leverage multiplier. D) an increase in the LIFO reserve. The correct answer was B) an understatement of the cost of goods sold (COGS). This is a LIFO liquidation which refers to a declining inventory balance (the units available for sale are declining). In this case the prices for goods that are being sold are no longer recent prices and can be many years out of date. This would make COGS appear to be very low and gross and net profits to be artificially high.
If the firm sells more inventory than it acquires or produces, where is the surplus coming from? From the LIFO reserve. What does it mean in an environment of inflation? That the company sells inventory from its reserves, therefore at lower prices under LIFO (where more expensive inventory is sold first), a price lower that it would cost the company to replenish the reserve. The COGS is lower (understated) because it is made of (partially at least) inventory from the reserve (at lower cost than on the market).
Because of the intensive selling, there is no more “recent” inventory, it’s moving out the door quickly. So, COGS is now coming from old “cheaper” inventory. It is understated.
Exactly, the key to this equation is inflation. If it’s dipping into inventory that is non-current, it’s not accurately reporting COGS.