Under the LIFO method, ending inventories comprise of units that are the oldest and hence have carrying values lower than the current replacement costs. However, cost of goods sold (COGS) under LIFO is more representative of the current replacement costs.
In an increasing price environment, LIFO would result in a higher COGS, lower gross profit, lower operating income, lower taxes, and lower net income. However, it would result in lower inventories, lower current assets, lower total assets, retained earnings, and shareholders equity. However, it would cause higher cash flows from operating activities. However, when the prices are decreasing, there are no tax advantages associated with LIFO.
LIFO reserve equals the excess of closing inventory value under FIFO over its value under LIFO. US GAAP requires companies to disclose the LIFO reserve. By adding the LIFO reserve to the closing inventory balance reported by a company using LIFO, an analyst can find out the equivalent FIFO value of inventories.
$$ FIFO\ value = LIFO\ value + LIFO\ reserve $$
Similarly, by subtracting any increase in LIFO reserve from the COGS of a company following LIFO, we can find the COGS under FIFO. Any decrease in the LIFO reserve is similarly added.
$$ COGS\ (FIFO) = COGS\ (LIFO) – Increase\ in\ LIFO\ Reserve $$
When prices are increasing, LIFO reserve increases because the difference between the LIFO value of inventories and their FIFO value increases. Further, as the inventory level increases i.e. when units produced or purchased exceed units sold, LIFO reserve increases because a new LIFO layer is added.
When the number of units sold exceeds units produced or purchased, a company starts utilizing the beginning inventories and the LIFO reserve starts to decline. This process is called LIFO liquidation. Since LIFO layers peeled off have lower inventory costs, this would cause a one-time increase in gross profit. LIFO liquidations can occur due to a variety of reasons, such as strikes or other production disruptions, etc. Sometimes, management may use it to manipulate their company’s profitability during downturns.