How to detect accounting gimmickry: LIFO liquidation
Management can exploit the LIFO accounting structure to artificially inflate their earnings by liquidating old LIFO layers. This is because the older and presumably lower costs in the LIFO layers are matched against sales amount that are stated at higher current prices. This results in an artificial rise in the profit margin. Below is an example of how it happens exactly.
Company XYZ had the following years in its LIFO inventory of at January 1, 2006,
At which time the cost of the inventory was $700 per unit.
Year LIFO Unit Total LIFO Reserve
Layer Added Units Cost as of 1/1/06
2003 10 $400 $4000 ($700-400) x 10 = $ 3000
2004 20 500 10000 ($700-500) x 20 = $ 4000
2005 30 600 18000 ($700-600) x 30 = $ 3000
60 $32000 $10000
Company XYZ sets its selling price by adding a $300 per unit markup to replacement cost at the time of sale. As of January 1, 2006 the replacement cost was $700; this cost level remained the same throughout 2006. During 2006 the company purchased 50 units at a cost of $700 per unit, and it sold 90 units at a price of $1000 per unit. Pre-tax LIFO income for 2006 is:
Sales revenue, 90 @ $1000 $90,000
Cost of goods sold:
2006 purchases, 50 @ $700 $35,000
2005 purchases, 30 @ $600 18,000
2004 purchases, 10 @ $500 5,000 58,000
LIFO Gross margin $32,000
Because the number of units sold (90) exceeded the number of units purchased in 2006 which is 50, the company was forced to liquidate its entire 2005 LIFO layer (30 in this case) and 10 units from its 2004 layer. If this happens, the matching advantages of LIFO in income statements will not take effect. As you can see, there is a mismatching that occurs since the reported LIFO margin is $32,000 / 90 = 355.56. This obviously overstates the true current cost operating margin of $300 per unit as stated previously. The excess $155.56 dollars in overstatement of the margin results because the cost of 2005 and 2004 inventories are being paired with the 2006 revenues.
In short, the $355.56 reported LIFO margin overstates the real margin used for pricing purposes which is $ 300 in this case. This increase is what any finance auditor would tag as unsustainable and misleading earnings number. It was just the result of an increase in inventory prices over time.
Let’s see the 2006 current cost operating margin:
Sales revenue 90 x 1000 $90,000
Replacement cost of goods sold 90 x 700 63,000
Current cost operating margin 90 x 300 27,000
The 2006 LIFO income of $32,000 exceeds the 2006 current cost margin of $27,000. The excess $5,000 dollars is the result of the mismatching as I have explained. This is an example how LIFO dipping can be used for accounting gimmickry.