LIFO reserves decline because a company is doing the following:

  • liquidating its inventory (lower quantities / selling cheap/old stock)
  • is purchasing inventory at lower prices (price decline)

The liquidation of inventory is called "LIFO liquidation". This happens when a company is no longer purchasing additional inventory (prices are high) and is depleting its old and cheap cost-base inventory. This can produce large increases in profitability (COGS abnormally low). This increase in profitability is temporary (paper profit). Once it runs out of cheap inventory, it will have to purchase new inventory at a mush higher cost base. This will also decrease a company's cash flow because it will have to pay more taxes. Profits from LIFO liquidation are non-operating in nature and should be excluded from earnings in an analysis.

A decline in price reduces the COGS under LIFO, but though COGS is lower it is a better indication of the economic reality. So no adjustments are necessary on the income statement. That said, the ending inventory under LIFO is too high and is no longer representative of its true economic value. The ending inventory should be adjusted to FIFO.

Look Out!

Companies must report inventories at the lower of cost (determined by their LIFO, FIFO or other inventory accounting method) or market value.

Market value is essentially the net realizable value of the assets.

Long Term Asset Basics

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