Inventory balances are significant because inventory cost accounting impacts reported gross profit margins. For an explanation of how this happens, see “Inventory Valuation For Investors: FIFO and LIFO.” Investors tend to monitor gross profit margins, which are often considered a measure of the value provided to consumers and/or the company’s “pricing power” in the industry. However, we should be alert to how much gross profit margins depend on the inventory costing method.

Walgreen’s represents our normal case and arguably shows the “best practice” in this regard: the company uses LIFO inventory costing, and its LIFO reserve increases year over year. In a period of rising prices, LIFO will assign higher prices to the consumed inventory (cost of goods sold) and is therefore more conservative. Just as COGS on the income statement tends to be higher under LIFO than under FIFO, the inventory account on the balance sheet tends to be understated. For this reason, companies using LIFO must disclose (usually in a footnote) a LIFO reserve, which when added to the inventory balance as reported, gives the FIFO-equivalent inventory balance.

As GAP Incorporated uses FIFO inventory costing, there is no need for a “LIFO reserve.” However, GAP’s and Walgreen’s gross profit margins are not commensurable–that is, comparing FIFO to LIFO is not like comparing apples to apples. GAP will get a slight upward bump to its gross profit margin because its inventory method will tend to undercount the cost of goods. There is no automatic solution for this. Rather, we can revise GAP’s COGS (in dollar terms) if we make an assumption about the inflation rate during the year.

Kohl’s Corporation uses LIFO, but its LIFO reserve declined year over year–from $4.98 million to zero. This is known as LIFO liquidation or liquidation of LIFO layers, and indicates that, during the fiscal year, Kohl’s sold or liquidated inventory that was held at the beginning of the year. When prices are rising, we know that inventory held at the beginning of the year carries a lower cost (because it was purchased in prior years). Cost of goods sold is therefore reduced, sometimes significantly. Generally, in the case of a sharply declining LIFO reserve, we can assume that reported profit margins are upwardly biased to the point of distortion.

Taken From : Advanced Financial Statements Analysis

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