LIFO Liquidation Definition, Example Effect on the Financial Statements

LIFO liquidation is the situation which company uses LIFO cost method, but the sale quantity is higher and the cost of goods sold matches the current cost. In LIFO, the cost of inventory sold will base on the old purchase item, it is called the cost layer. But when the company sells a huge amount of stock, they will use all the items in the previous cost layer. As a result, the cost of inventory will equal the most recent purchase. A LIFO liquidation occurs when an organization using the last in, first out concept to track its inventory costs uses up its oldest inventory layer. Under the LIFO method, the cost of the last inventory acquired is assigned to the first inventory used.

FAQ: Commonly Asked Questions About Last In, First Out (LIFO) Method

In order to help you advance your career, CFI has compiled many resources to assist you along the path. Following this, the 250,000 units from 2019 would be liquidated, followed by 250,000 units from 2018. Many law amendments have been made and are still in place to bound companies’ compliance to more ethical practices.

However, lower net income under LIFO can impact financial performance metrics like EPS (Earnings Per Share) and ROE (Return on Equity). Last In, First Out (LIFO), as a method for inventory accounting, has significant implications for net income and taxes. By recording the most recently purchased or produced items as sold first, LIFO lowers net income lifo liquidation due to higher cost of goods sold (COGS).

LIFO and Financial Reporting: Implications for Shareholders and Analysts

In this scenario, FIFO can help businesses report higher net income and lower taxes due to lower COGS. LIFO, Last-in First-Out, is the method that we use to calculate the cost of goods sold based on the recent cost of inventory. The cost of stock, which is the last purchase, will be used to calculate the cost of goods sold. It is not related to the physical movement of the goods as it is almost impossible to track the actual inventory when we sell thousands of them. We use this method to calculate the cost of inventory sold and the valuation of the remaining stock. Some companies use the Dollar-value LIFO method for inventory liquidation.

When a sufficient number of units have been withdrawn from stock to eliminate an entire cost layer, this is termed a LIFO liquidation.
LIFO liquidation refers to the practice of discount selling older merchandise in stock or materials in a company’s inventory.
We use this method to calculate the cost of inventory sold and the valuation of the remaining stock.
Industries that typically use LIFO include retailers, automobile dealerships, and other businesses with substantial inventories, as they can take advantage of tax savings during periods of price inflation.
The most commonly used methods are FIFO (First-in First-out), LIFO (Last-in, First-out), and Weighted Average cost.
However, demand suddenly rose in 2022, and XYZ sold 1,000,000 units of product A in 2020.

Many companies avoid such a liquidation due to the sudden and significant impact this can have on its profit and taxes. There are 2,000 units remaining at the end of the month, and they will value base on the old cost. There are 2,000 units (5,000 units – 2,000 units) remaining at the end of the month, and they will value base on the old cost. Since the company follows LIFO Method, 1 million units will be priced at the latest inventory. The company managed to sell 1,000,000 units in every subsequent year.

The use of different inventory costing methods can lead to misinterpretation of a company’s financial position and performance. Therefore, it’s essential for companies using LIFO to provide clear explanations and disclosures regarding their inventory accounting methods in their financial reports. The first five units cost $100 each, arriving two days ago, whereas the remaining five units cost $200 each and were delivered one day ago. Applying the LIFO method of inventory management, the last items in are the first sold, meaning that the $200 widgets were sold first, followed by two $100 widgets.

The company usually keeps some inventory in warehouse in order to prevent any shortage, and these inventories are known as inventory minimum level. The purchasing department will place the order when the inventory level is approaching this level. It is the inventory level that company place order and receive material without disturbing the production process. It also helps to minimize the storage cost which incurs when company stores inventory more than it needs.

LIFO Liquidation

This situation can arise when management decides to retain fewer units on hand, perhaps due to a cash flow crunch. This situation can also arise when an unexpected surge in demand wipes out a large part of a firm’s inventory reserves. Because the company employs a LIFO method, the most recent layer, 2022, would be liquidated first, followed by 2021 layer and so on. 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. LIFO liquidation causes distortion of net operating income and may become a reason of a higher tax bill in current period.

Understanding LIFO Liquidation

Inflation, Net Income, and LIFOLIFO provides a more accurate reflection of the cost of goods sold during periods of inflation when prices are rising. However, this results in lower reported net income and earnings per share (EPS). The lower net income under LIFO can result in less taxable income as well since taxes are calculated based on net income.

How Does It Impact Net Income?

The expected tax advantage of LIFO turns into a disadvantage because older, lower costs (of older inventory) are matched with current revenues.
However, it can also present disadvantages, like a potential understatement of inventory values and lower reported net income.
Under LIFO, a company uses the most recent costs when selling inventory items.
But it is not a best practice under the ethical norms of doing business.
To summarize, the Last In, First Out (LIFO) method is an essential inventory accounting technique used in the United States.

The tax savings from using this method can be significant and contribute to higher cash flows in certain market conditions. However, it’s essential for investors and analysts to consider the potential impact on financial reporting when evaluating companies that use LIFO. By illustrating the example, we gained insights into how LIFO differs from other inventory methods like FIFO and the average cost method.

The customers will be looking to purchase the new fresh stock even if the quality is similar. To solve this problem, the warehouse manager arranges the old stock and tries to sell them before they are too old. Some companies may provide discounts on the old stock to increase sales. Electron Corporation uses the LIFO inventory method for accounting.