The LIFO Reserve and LIFO Liquidation Profits
The LIFO reserve shows how much lower a company's reported inventory is under LIFO than it would be under FIFO, and a LIFO liquidation is what happens when old, cheap inventory layers get sold off and artificially inflate profit.
Prerequisites: Percentage-of-Completion Revenue Recognition
Under LIFO (last-in, first-out) inventory accounting, a company assumes the most recently purchased units are the first ones sold, leaving older, often cheaper, units still sitting on the books as inventory. The LIFO reserve, disclosed in footnotes, is simply the difference between what inventory would be valued at under FIFO and what it's actually reported at under LIFO — it tells you how much LIFO has depressed the reported inventory (and, cumulatively, reported profit) relative to FIFO.
The LIFO reserve equals FIFO inventory value minus LIFO inventory value; adding it back to reported inventory (and to cumulative cost of goods sold) converts LIFO-based statements to a FIFO-equivalent basis, which is essential for comparing a LIFO company against a FIFO peer.
What a LIFO liquidation is
Because LIFO always sells the newest layer first, older, cheaper "layers" of inventory can sit untouched for years. If a company ever sells more units than it purchased in a period — say, a supply disruption or a deliberate inventory drawdown — it starts dipping into those old, low-cost layers. The result is unusually high reported profit that period, since decades-old, cheap costs are matched against today's sale prices — a one-time boost that doesn't reflect the current cost environment at all.
Worked example
A retailer's oldest inventory layer, from 15 years ago, cost $10 per unit; today's replacement cost is $40 per unit. A supply shortage forces the company to sell 100,000 units from that old layer at today's price of $60. Under LIFO, cost of goods sold for those units is booked at $10 each ($1 million total) against $6 million of revenue, producing a gross profit of $5 million — far higher than the roughly $2 million the same sale would generate at today's $40 replacement cost, purely because an old, cheap layer was liquidated.
A LIFO liquidation profit is not repeatable operating performance — an analyst who takes a quarter's earnings at face value after a large LIFO liquidation is capturing a one-time accounting artifact from decades-old costs, not a genuine improvement in the business's margins.
Further reading
- White, Sondhi and Fried, The Analysis and Use of Financial Statements (ch. 7)