What it means
Under LIFO (last in, first out), the latest purchases are treated as the first goods sold. The cost of goods sold therefore reflects recent prices, while the inventory left on the balance sheet reflects older, usually lower prices.
Over many years of rising prices, a company builds up old layers of inventory at very low costs. As long as it keeps buying at least as much as it sells, these layers sit untouched.
If sales exceed purchases, whether because of strong demand, supply problems or a deliberate stock reduction, the company must dip into the old layers. The low historic costs flow into cost of sales, which lifts gross profit above what current prices would produce.
The extra profit is a paper gain, not a real improvement in the business. In a jurisdiction where LIFO is used for tax, it can also increase taxable income, so cash leaves the company as tax even though the company has less inventory.
Analysts watch for LIFO liquidation in the notes to the accounts. Companies that use LIFO often disclose the effect of liquidations, and careful readers adjust earnings to see underlying performance.
The method is allowed under US accounting rules but not under international standards, so the issue arises mainly for US-reporting firms. A company may also choose to avoid it by making year-end purchases that restore the layers.
In practice
Real-world examples.
Example
A hardware distributor cuts its stock of copper pipe because suppliers are late. Its sales continue, so it draws on pipe bought years ago at much lower prices. Its quarterly profit jumps, and the finance director explains in the notes that this was a liquidation of old layers.
Example
A car parts retailer reduces inventory at year end to improve its cash position. The LIFO liquidation adds $400,000 to profit and creates a tax bill the budget did not include. The controller learns to check inventory levels before year end.
Example
An equity analyst examines a US industrial company whose profit margin rose sharply. She reads the footnotes and finds that most of the gain came from a LIFO liquidation. She removes the one-off effect from her forecast.
Formula
Calculation
Profit effect of liquidation = Units liquidated x (Current cost - Old layer cost)
Suppose a company starts the year with 2,000 units from an old layer costing $10 each, buys 8,000 units at $20, and sells 9,000 units at $35. Cost of goods sold under LIFO = (8,000 x 20) + (1,000 x 10) = 160,000 + 10,000 = $170,000, and revenue is 9,000 x 35 = $315,000, so gross profit is $145,000. Had it bought 9,000 units at $20, cost of goods sold would be 9,000 x 20 = $180,000 and gross profit $135,000. The liquidation added 1,000 x (20 - 10) = $10,000 of profit, which at a 25% tax rate means $2,500 of extra tax. The point of the example is that the extra $10,000 comes entirely from the cheaper old layer and has nothing to do with selling more efficiently. Analysts often call this a low-quality earnings gain, because it cannot be repeated once the old layer has been used up.Case study
Seen in the real world.
Dunmore Fasteners is an illustrative, fictional manufacturer using LIFO. Over 15 years it has built an old inventory layer of 50,000 units costing $2 each, while current purchases cost $5. A supply disruption forces it to sell 20,000 units from the old layer without replacing them.
The cost of those units is 20,000 x 2 = $40,000 instead of 20,000 x 5 = $100,000, so gross profit rises by $60,000. At a 25% tax rate, the company owes $15,000 more tax. The finance team explains the gain in its report as non-recurring, and it restores the stock the following year. The numbers are invented.
The auditors asked the company to quantify the effect in its notes, and the controller prepared a short schedule showing the old layer, the units drawn down and the resulting tax. The disclosure helped investors see that underlying profit had not changed.
Watch out
Common mistakes.
- Treating the extra profit as a sign of better performance. It comes from old costs, not from improved operations.
- Forgetting the tax cost. Higher taxable profit can mean a surprise payment.
- Assuming only large firms are affected. Any LIFO user that lets stock levels fall can have a liquidation.
Questions
People also ask.
What is a LIFO layer?
It is a block of inventory purchased at a given price in a given period that stays on the books at its original cost.
Can a company avoid LIFO liquidation?
Yes, by buying enough stock before the period ends to keep its layers intact.
Is LIFO allowed everywhere?
No, it is permitted under US rules but not under international financial reporting standards.
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