What Is LIFO Liquidation, How It Works, Example

LIFO liquidation causes distortion of net operating income and may become a reason of bookkeeping providence a higher tax bill in current period. When LIFO inventory is liquidated, the old costs are matched with the current revenues and as a result, financial statements show higher income. The LIFO liquidation, therefore, causes a higher tax liability in periods of high inflation. LIFO liquidation occurs when a company, using LIFO inventory valuation method, sells (or issues) the old stock of merchandise (or raw materials) inventory.

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Recall that with the LIFO method, there is a low quality of balance sheet valuation. Therefore, the balance sheet may contain outdated costs that are not relevant to users of financial statements. LIFO is an inventory management system in which the items most recently added to a company’s stock are the first ones to be sold or used. The later costs recorded on the materials ledger cards are used for costing materials requisitions, and the balance consists of units received earlier.

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Generally, the company sells the most recent inventory in the LIFO method. However, there are certain scenarios, economic conditions, and implications that a company has to delayer its older stock or inventory. The process of selling the older merchandise stock or issuing older raw material inventory to the manufacturing department is called LIFO Liquidation. The net income in the LIFO method is lower as the latest inventory has a higher cost. It offers the benefit of lower corporate tax to the business using the LIFO method.

Macrons & Macrons is a consumer product company and uses the LIFO method of inventory valuation. The cost per unit was $9 in year 1, $12 in year 2, and $15 in year 3. When they begin selling inventory beyond that most recent purchase, the process is known as liquidation. As the company goes further back into their LIFO layers, they begin to sell their older, lower-cost inventory reserves. The process provides a lower cost of goods sold (COGS), which increases gross profits, and generates more income to be taxed. LIFO liquidation can distort a company’s net operating income, which generally leads to higher taxable income.

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Some of the more important problems include the effects of prices, LIFO liquidation, purchase behavior, and inventory turnover. They should be entered in the materials ledger card balance below all of the units on hand, at the same price as they were when issued to the factory. In other words, under the LIFO method, the cost of the most recent lot of materials purchased is charged until the lot is exhausted. Last in, first out (LIFO) is only used in the United States where any of the three inventory-costing methods can be used under generally accepted accounting principles (GAAP). The International Financial Reporting Standards (IFRS), which is used in most countries, forbids the use of the LIFO method. While LIFO liquidation, inventory may be segregated and pooled together with similar other items (forming groups of items) for better and more realistic calculation.

1. For example, consider a company with a beginning inventory of 100 calculators at a unit cost of $5.
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3. Periodic segregation of inventory based on a particular frequency for calculation of closing stocks.
4. Therefore, the balance sheet may contain outdated costs that are not relevant to users of financial statements.
5. This combination or group of similar items is referred to as pool.

It is not recommended for situations where stock needs to remain consistent or bulk discounts are available. For example, in 2018, a number of sugar companies changed to LIFO as sugar prices rose at a rapid pace. When materials are returned how to do a competitive analysis in 2021 from the factory to the storeroom, they should be treated as the most recent stock on hand.

Although firms can often plan for LIFO liquidation, events sometimes happen that are beyond the control of management. This is because the latest and, in this case, the lowest prices are allocated to the cost of goods sold. In contrast, using the FIFO method, the $100 widgets are sold first, followed by the $200 widgets. So, the cost of the widgets sold will be recorded as $900, or five at $100 and two at $200.

One potential downside to LIFO is that it can lead to higher inventory costs as old items must be replaced frequently. Additionally, businesses may not be able to take advantage of bulk discounts since only a few items are purchased at a time. Many companies frequently change their sales mix as they grow their business. This approach may prove costly as well as time consuming for such companies because they have to redefine the inventory pools each time a change in mix of their products occurs. To overcome the problem that LIFO liquidation creates, some companies adopt an approach known as specific goods pooled LIFO approach. Under this approach, a number of similar products are combined and accounted for together.

How a LIFO Liquidation Works

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The remaining unsold 450 would remain on the balance sheet as inventory for $1,275. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. LIFO is best suited for situations in which inventory needs to remain up-to-date and turnover is high, such as in retail stores or warehouses.

The lower net income is characterized by, the higher corporate tax liability. Some of the experts and managerial gurus suggest LIFO Inventory Pool prevents the impact of LIFO Liquidation on the net income. The lower cost of older inventory is offset by the high cost of another item in combination. Each category tells about the number of units, cost per unit, total cost, etc., for the remaining inventory of a particular period. The categories are collectively called LIFO Layers or individually as LIFO Layer.

The cost of materials is charged to production in the reverse order of purchases. After this, the price of the next most recent lot is charged to the job, department, or process. Many companies prefer using LIFO Liquidation as compare to the FIFO Inventory.

This liquidation would enforce the company to match old low costs with the current higher sales prices. The income statement of Delta would, therefore, show much higher profits that would eventually lead to higher tax bill in the current period. ABC Company uses the LIFO method of inventory accounting for its domestic stores. It purchased 1 million units of a product annually for three years. The per-unit cost is $10 in year one, $12 in year two, and $14 in year three, and ABC sells each unit for $50. It sold 500,000 units of the product in each of the first three years, leaving a total of 1.5 million units on hand.

Sometimes, companies follow more than inventory management methods for different types of stocks. Hence, there is a difference between actual and LIFO inventory, known as LIFO reserve. Varying inventory valuation methods are used by different business organizations. The most commonly used methods are FIFO (First-in First-out), LIFO (Last-in, First-out), and Weighted Average cost. If the company made a sale of 50 units of calculators, under the LIFO method, the most recent calculator costs would be matched with the revenue generated from the sale. It would provide excellent matching of revenue and cost of goods sold on the income statement.