LIFO Liquidation Effect on LIFO Reserve

Neither is coffee – I was out with friends and learned that coffee and sheisha doesn’t mix

Though these days I overdose on coffee every other day….

Sorry to resuscitate the discussion, but I agree with the original comment that LIFO-Reserves do not decrease due to LIFO liquidation. In fact, there are only two instances when LIFO-Reserves decrease:

(1) in a deflationary environment — a less typical situation — and
(2) when one changes the method from LIFO to FIFO — trivial case when the LIFO-Reserve disappears
—

Let’s look at the math: From the definition of LIFO-Reserve:

LIFO-Reserve = FIFO-Inventory – LIFO-Inventory

so that

Change in LIFO-Reserve = Change in FIFO-Inventory – Change in LIFO-Inventory

But each change in inventory is given by:

Change in FIFO-Inventory = Units purchased * Current Cost of Purchase – Units sold * FIFO-COGS
Change in LIFO-Inventory = Units purchased * Current Cost of Purchase – Units sold * LIFO-COGS

where COGS is “cost of goods sold per unit”. Substituting:

Change in LIFO-Reserve = Units sold * (LIFO-COGS – FIFO-COGS)

This amount is always positive in an inflationary environment and always negative in a deflationary environment, which covers case (1) above. Note that the change in inventory units (units purchased – units sold) will not affect the sign of the change in LIFO-Reserve.

So what is a LIFO liquidation?

A LIFO liquidation is NOT (and it does not cause) a decrease in LIFO-Reserve. A LIFO liquidation is a decrease in inventory units (when one is using the LIFO method), in other words, it’s the result of “burning” old inventory which was bought at prices lower than current prices (in the typical inflationary environment) but still higher than the costs accounted under FIFO. In an inflationary environment, a LIFO liquidation causes a smaller increase in the LIFO-Reserve than what would have been if instead the inventory units had not decreased during the period (that is, the company had produced at least the same amount that it sold during the period). In the less typical deflationary environment, it causes a smaller decrease in the LIFO-Reserve than what would have been otherwise.

So instead of looking for a decrease in LIFO-Reserve in order to find the possibility of earnings management, one needs to look for small increases in LIFO-Reserve, since that is what characterizes a LIFO liquidation.

Any comments, challenges, etc. are very welcome!

I take this all back… (yeah, it’s late). I have just seen a counter-example where there is a decrease in LIFO-Reserve in a LIFO liquidation situation, and it’s not a deflationary environment. Rather than try to re-prove it mathematically, I’ll simply accept that the above calculations are perhaps too simplistic.

A great example of how explaining/reasoning your thoughts out here on various topics helps strengthen your understanding! Nice one @Dollarstodonuts, @diya

Urgh. I think I will always have problems with hardcore Level 2 topics no matter what I do. 😀

I know, I went to a leaving party last night and was on the soft drinks…too much diet coke is not a good thing!

@Dollarstodonuts no problem!
@mattjuniper one drink and I’m useless to work for the rest of the day…

I think you have grasped the concept!

LIFO liquidation means you are tapping into the LIFO reserve so in turn LIFO reserve must be decreasing. Basically you are releasing cheaper inventory that was stored on your balance sheet to your income statement through COGS.

You should flag LIFO liquidation as it bolster net income for that period and it is unsustainable – therefore you might be required to do an adjustment if you are working out some sort of analysis. Of course LIFO liquidation doesn’t always happen due to management trying to manage earning and there can be legitimate reasons like a sharp increase in demand.

You should flag LIFO liquidation as it bolster net income for that period and it is unsustainable.

That’s the key right there. LIFO inventory in this case is a cache of ‘extra profit’, i.e. when you dip into your LIFO reserve you start reporting a higher net profit simply because you’re selling goods that you accounted for in your books as cheaper than usual (because of LIFO).

So for fair representation you should flag up LIFO liquidation for better analysis of your books.

Great explanations. I just wonder whether its just me, or do previous level concepts do appear vague usually 🙁

@Christine At times you’re just not able to recall some of the concepts you studied previously. Its like its stored in some part of your brain, and once you come across it, you realise you did study it. Something like feeling unfamiliar about some topic, when in fact you are familiar.

@christine yea some concepts do come back. However, I think I would have a problem with many hardcore Level 2 topic areas, unless I revisit them 🙂

Great explanations. I just wonder whether its just me, or do previous level concepts do appear vague usually 🙁

The whole curriculum across levels 1, 2 and 3 appears vague to me!

@MattJuniper and @AjFinance don’t worry too much it is simply the curve of forgetting kicking in.

“curve of forgetting,” quantified by a German psychologist who found that in the first hour after learning a set of nonsense syllables, more than half of them would be forgotten; after a day, another 10 percent would disappear; and after a month, another 14 percent.

@MattJuniper Originally I wanted to write the first level exam in June but I postponed it to December since I had far too many weddings to attend and since one was of a very close associate I had to be part of far too many events.

I am absolutely dreading May, I already have two official wedding invites and know that a third will come knocking at my door soon. Coming up with excuses to skip some of the events and having to face them late is going to be dreadful. I want to go hide in some other part of the world T.T

Great explanations. I just wonder whether its just me, or do previous level concepts do appear vague usually 🙁

The whole curriculum across levels 1, 2 and 3 appears vague to me!

yea it just evaporates into thin air ~X(

Vague in what sense @ajfinance?

@ajfinance ah yes – that is true when I was going through the program. I think Level I crystalises a lot more when you’re in Level III though.

@christine yea some concepts do come back. However, I think I would have a problem with many hardcore Level 2 topic areas, unless I revisit them 🙂

I don’t think many Level 3 topics need Level 2 mastery (unlike Level 2 that needs Level 1 to be thoroughly expertized), or is it just me?

@artyeasel yep. Level 3 is all about Portfolio Management. Thats what we level 3ers have dreams and err.. nightmares about I guess 😛 I was just referring to recalling previous level concepts in general.

@diya

“curve of forgetting,” quantified by a UK CFA Level 3 candidate who found that after the first beer in an evening, some of what he had learnt would be forgotten; after 2 beers, most of it would be forgotten; and after too many beers he would wake up in a ditch…!

@MattJuniper ROFL

on a more serious note I don’t touch alcohol since it messes with my precious memory too much 😛
Alcohol has long-term and short-term affects on memory.

I always look forward to the night after the exam, but I remember the last two years just being absolutely exhausted and wanting to go straight to bed! The problem was that my housemates birthday was 30th May, and each year I made him postpone his birthday party until after my exam was over, so I had to go out and celebrate with him on exam night! After level 1 we did end up in the casino though and I remember doing particularly well at blackjack 😀

One more… (I promise it will be the last on the topic, unless of course someone wants to discuss it further 🙂 )

I figured out what happens. The analysis in my long post above is correct, except that it is not necessarily the case that LIFO-COGS is always greater than FIFO-COGS in an inflationary environment. It’s possible, when there is a LIFO liquidation of very early “layers” of inventory, that the LIFO-COGS is lower than the FIFO-COGS; for this to happen, it has to be a “burn” of inventory from enough periods back for the recognized cost to be low enough, while under FIFO you are recognizing the cost of more recently purchased inventory. When doing the analysis, I had in mind a “burning” of more recent layers of inventory and reasoned the LIFO-COGS would always be larger than the FIFO-COGS in inflationary environment; but this doesn’t have to be the case.

A good (made up) example to see this is the Example 4 in the CFAI Level II 2014 text (end of section 3 in Reading 17), but you need to calculate the FIFO amounts and the LIFO-Reserve yourself in order to see this.

In the end, I still think that it is much more likely to see smaller increases in the LIFO-Reserve than a decrease, when there is LIFO liquidation in an inflationary environment; but it is definitely possible to have a decrease as well.