LIFO Liquidation Definition, How it Works, Why

The units from year 3 will be 500,000, and COGS will be $7.5 million. Most companies use LIFO for only reporting purposes to achieve tax savings. In this article, we’re going to understand the concept of LIFO Liquidation. You will be walked through the reasons why the company uses LIFO liquidation, its process, example, merits, and demerits. These materials were downloaded from PwC’s Viewpoint (viewpoint.pwc.com) under license. Specific goods pooled LIFO approach is not a perfect solution of LIFO liquidation but can eliminate the disadvantages of traditional LIFO inventory system to some extent.

Absorption Costing: Definition, Formula, Calculation, and Example

It might be tempting for the reason of understating income and tax evasions. But it is not a best practice under the ethical norms of doing business. Since the company follows LIFO Method, 1 million units will be priced at the latest inventory.

Using LIFO can help prevent obsolescence by ensuring out-of-date items are sold or used before they become obsolete. Additionally, it helps companies better manage their stock levels and ensure they have the most current products available. With LIFO, when a new item arrives on the shelf it will replace the oldest item of that type and be sold or used first. This helps companies keep their stock up-to-date with current products and customer demand. If a company uses a LIFO valuation when it files taxes, it must also use LIFO when it reports financial results to its shareholders, which lowers its net income. The impact of the LIFO Liquidation on the net income is usually implied by the higher gross profits but lower net income.

The total cost of goods sold for the sale of 350 units would be $1,700. In summary, choosing principles of accounting that can guide both financial reporting and tax strategy is an important management decision. The result of this decline was an increase in earnings and tax payments over what they would have been on a FIFO basis.

Therefore, the inventory profits usually found in connection with FIFO are substantially decreased. When a company has a high turnover rate, the advantage of LIFO over FIFO is not massive. Purchases at the beginning of the next year, however, could end up in next year’s ending inventory as a new LIFO layer.

LIFO Liquidation:

In addition, there is the risk that the earnings of a company that is being liquidated can be artificially inflated by the use of LIFO accounting in previous years. Last in, first out (LIFO) is a method used to account for business inventory that records the most recently produced items in a series as the ones that are sold first. Sometimes a business might use multiple inventory valuation methods.

How a LIFO Liquidation Works

We note from the above SEC Filings; that the company mentions that the inventory quantities were reduced. The carrying cost of the remaining inventory is lower than that of the previous year. If this situation continues for the remaining part of the year, the LIFO liquidation may happen and will impact the results of operations. The remaining 7 lac of the units will be taken from year 3 and year 2.

Definition of LIFO Liquidation:

It is done by companies that are using the LIFO (last in, first out) inventory valuation method. The liquidation occurs when a company using LIFO wants to get rid of old and perhaps obsolete inventory quickly. Because the company employs a LIFO method, the most recent layer, 2022, would be liquidated first, followed by 2021 layer and so on.

But, it has an impactful consequence on the financial statements indeed. You might have seen something while going through any company’s financial statements. LIFO Liquidation most commonly occurs when the company sells more items than it has purchased. Since LIFO expenses the newest costs, there is better matching on the income statement. The revenue from the sale of inventory is matched with the cost of the more recent inventory cost.

1. The most commonly used methods are FIFO (First-in First-out), LIFO (Last-in, First-out), and Weighted Average cost.
2. This is because the latest and, in this case, the lowest prices are allocated to the cost of goods sold.
3. In periods of deflation, LIFO creates lower costs and increases net income, which also increases taxable income.
4. But it is not a best practice under the ethical norms of doing business.

For example, consider a company with a beginning inventory of 100 calculators at a unit cost of $5. The company purchases another 100 units of calculators at a higher unit cost of $10 due to the scarcity of materials used to manufacture the calculators. Some companies use the Dollar-value LIFO method for inventory liquidation. As per this method, the current value of the inventory is first discounted to the base layer based on the cpa vs mba salary current inflation rate. Then the real dollar increase is determined, which is then escalated to arrive at the real value of inventory at present (and not the current value based on current cost prices). It is the difference between inventory calculated by methods other than LIFO and the inventory calculated per LIFO.

Assuming that demand will remain constant, it only purchases 500,000 units in year four at $15 per unit. Last-in First-out (LIFO) is an inventory valuation method based on the assumption that assets produced or acquired last are the first to be expensed. In other words, under the last-in, first-out method, product cost formula the latest purchased or produced goods are removed and expensed first. Therefore, the old inventory costs remain on the balance sheet while the newest inventory costs are expensed first. LIFO liquidation occurs when a firm sells more units than it purchases in any year. Thus, LIFO layers that have been built up in the past are liquidated (i.e., included in the cost of goods sold for the current period).

But at the same time, there are some consequences a business organization has to accept as a result. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. The company would report the cost of goods sold of $875 and inventory of $2,100. In the following example, we will compare it to FIFO (first in first out).

LIFO method implies that the inventory purchased in most recent times is used first, and the older inventory stays in. According to this rule, management is forced to consider the utility of increased cash flows versus the effect LIFO will have on the balance sheet and income statement. Inventory turnover is the rate at which a company sells its inventory. Inventory turnover can influence the differential between FIFO and LIFO. This will happen if the units purchased during this year exceed the units sold. In any case, by timing purchases at the end of the year, management can determine what costs will be allocated to the cost of goods.