Rating - 4/5

The carrying values of inventories maintained under the LIFO method are sometimes significantly understated in relationship to their replacement cost. For public companies, the difference between the LIFO carrying value and replacement cost (frequently approximated by FIFO) is a required disclosure under SEC regulations. An example of a substantial difference between LIFO and current replacement value is found in a summary of the inventory disclosures of Handy and Harman Inc. in Exhibit 2.17.

A reduction in the physical inventory quantities of a LIFO inventory is called a LIFO liquidation. With a LIFO liquidation a portion of the firm’s cost of sales for the year will consist of the carrying values associated with the liquidated units. These costs are typically lower than current replacement costs, resulting in increased profits or reduced losses.

As with the differences between the LIFO cost and the replacement value of the LIFO inventory, SEC regulations also call for disclosures of the effect of LIFO liquidations. Handy and Harman had LIFO liquidations in both 1996 and 1997. In line with these SEC requirements, Handy and Harman provided the following disclosure of the effects of these inventory reductions:

Included in continuing operations for 1996 and 1997 are profits before taxes of $33,630,000 and $6,408,000, respectively, from reduction in the quantities of


precious metal inventories valued under the LIFO method. The after-tax effect on continuing operations for 1996 and 1997 amounted to $19,260,000 ($1.40 per basic share) and $3,717,000 ($.31 per basic share), respectively.

The effect of the Handy and Harman LIFO liquidation is quite dramatic. Including the effects of the LIFO liquidations, Handy and Harman reported after-tax income from continuing operations of $33,773,000 in 1996 and $20,910,000 in 1997. Of the after-tax earnings from continuing operations 57% in 1996 and 18% in 1997 resulted from the LIFO liquidations. Handy and Harman reported benefits from LIFO liquidations for most years between 1991 and 1997.

Although Handy and Harman reported LIFO liquidations with some regularity, an analysis of sustainable earnings should consider the profit improvements from the liquidations to be nonrecurring. The LIFO-liquidation benefits result from reductions in the physical quantity of inventory. There are obvious limits on the ability to sustain these liquidations in future years; as a practical matter, the inventory cannot be reduced to zero. Moreover, the variability in the size of the liquidation benefits argues for the nonrecurring classification. The profit improvements resulting from the LIFO liquidations simply represent the realization of an undervalued asset and are analogous to the gain associated with the disposition of an undervalued investment, piece of equipment, or plot of land.

A statement user cannot rely on the disclosure requirements of the SEC when reviewing the statements of nonpublic companies, especially where an outside accountant has performed only a review or compilation. However, one can infer the possibility of a LIFO liquidation through the combination of a decline in the dollar amount of inventory across the year and an otherwise unexplainable improvement in gross margins. Details on the existence and impact of a LIFO liquidation could then be discussed with management.

Rating - 4/5