LIFO

LIFO is an accounting convention applied to the cost pool, not a warehouse instruction. Each period the company matches the cost of its most recent purchases against revenue, so the income statement carries costs close to current replacement levels while the balance sheet accumulates layers of older, unsold cost. Under a periodic system the calculation is performed once at period end using total purchases for the period; under a perpetual system it is applied at each sale date, so the two methods can produce different figures for the same transactions, unlike FIFO where the results coincide.

The consequence in a rising-cost environment is systematic: cost of goods sold is higher, gross profit and net income are lower, and inventory on the balance sheet is understated relative to current cost, sometimes by decades. When costs fall, every one of these effects reverses.

US GAAP requires LIFO users to disclose the LIFO reserve, the gap between inventory measured on LIFO and what it would be under FIFO or current cost. This single number in the inventory footnote is the analyst's bridge to comparability. Adding the reserve to reported inventory gives inventory on a FIFO basis. Subtracting the change in the reserve over the period from reported cost of goods sold gives COGS on a FIFO basis, because the increase in the reserve is precisely the extra cost LIFO pushed into the income statement.

The balance sheet adjustment must also be squared. Retained earnings rise by the reserve net of tax, and a deferred tax liability equal to the reserve multiplied by the tax rate is recognised, since the cumulative tax deferral would reverse if the LIFO layers were consumed. Current assets and equity both rise, so current ratio improves while inventory turnover falls.

When a LIFO firm sells more units than it purchases, it dips into old cost layers. Those layers were laid down at prices that may be a fraction of current cost, so they flow into COGS at artificially low amounts and gross margin balloons. The profit is real in accounting terms but is not sustainable, is not driven by operations, and carries an immediate cash tax cost because the deferred tax reverses. A shrinking LIFO reserve is the standard warning signal, and the footnote usually quantifies the effect on income.

Liquidations arise from deliberate inventory drawdowns, from supply disruptions that prevent replenishment, and from declining business volumes. Analysts strip the disclosed liquidation gain out of operating income before assessing margin trends or building forecasts.

LIFO is confined to US filers, concentrated in energy, chemicals, metals, industrial distribution and some retail, where inventories are large, homogeneous and cost-inflating. The US tax code's conformity rule means a company claiming the LIFO tax benefit must also use LIFO in its published financial statements, which is why the reported earnings penalty is accepted. IFRS reporters have no such option, so cross-border comparisons of a US industrial against a European peer are meaningless until the US firm is restated to FIFO.

At Level I you should be able to state the direction of LIFO's effect on COGS, gross profit, net income, inventory, working capital and cash flow under rising and falling costs; perform the reserve-based conversion in both directions; identify a liquidation from the footnote; and recompute margin, liquidity, activity and solvency ratios on the adjusted figures.