Professor Adams' Lecture Materials

LO8-06: Understand supplemental disclosures of LIFO reserves and the effect of LIFO liquidations on net income.

LIFO reserves

Many companies use LIFO for external reporting, but FIFO or average cost for internal reporting. Reasons:

1. the cost of record keeping is higher for LIFO,
2. some compensation contracts (e.g., for the CEO or CFO) base bonus calculations on FIFO or average cost, and
3. product pricing decisions are often based upon FIFO or average cost.

If FIFO or average cost is used internally and LIFO is used for external reporting, a conversion must be completed to generate external financial statements. The conversion results in an adjustment amount called the LIFO reserve.

LIFO liquidations

Say a company company follows LIFO and its inventory balance decreases between the beginning of the year and the end of the year. When this happens, inventory costs from old "inventory layers" end up in Cost of Goods Sold. Assuming inventory costs increase over time, the effect of including old "inventory layers" in Cost of Goods Sold is a relatively low Cost of Goods Sold and, therefore, relatively high net income. When this happens, we say there has been a LIFO liquidation. [01]

If the effect of LIFO liquidation on income is material, the company must disclose the effect in the notes to the financial statements.

Footnotes

[01] Liquidate: to convert assets into cash.

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