LIFO Liquidation

What is LIFO Liquidation?

LIFO liquidation is an event of selling old inventory stock by companies that follow the LIFO Inventory Costing Method. During such liquidation, the stocks valued at older costs are matched with the latest revenue after sales, due to which the company reports higher net income which results in payment of higher taxes.

We note from the above SEC Filings; the company mentions that the inventory quantities were reduced due to which the carrying cost of the remaining inventory is lower than that of the previous year. If this situation continues the remaining part of the year, the LIFO liquidation may happen and will result in an impact on the results of operations.

LIFO Liquidation

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For eg:
Source: LIFO Liquidation (wallstreetmojo.com)

Example of LIFO Liquidation

ABC Company manufactures menswear shirts and has the following textile inventory, based on periodic cycles:

LIFO Liquidation Example 1-1

Suppose that ABC has to complete an order of 250 shirts and assume that for each shirt, 1 unit of raw material is used up. To complete the order, ABC will have to liquidate a complete April inventory of 120 units, March inventory of 90 units, and 40 units from February inventory.

This is known as LIFO Liquidation, where the last in stock is first out followed by the next layer and so on based on the requirement.

Now, based on the sales, consider each shirt is sold for $20.00, the revenue generated is $5,000.00. However, the cost of raw material is calculated as below:

Example 1

If all Raw Material was procured in April?

In such a situation wherein the company would have procured all the raw material in April based on the requirement, then below would have been cost and revenue calculation:

raw material cost = $13 x 250 = $3,250/-

Example 2

In this case, the company would have reported a lower net income.

Here, we note that in the case of such liquidation,

LIFO Liquidation Terminologies

LIFO liquidation has certain terminologies, as mentioned below:

#1 – LIFO layer

Periodic segregation of inventory based on a particular frequency for calculation of closing stocksCalculation Of Closing StocksClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level.read more. This term provides the number of units, cost/unit, the total cost of inventory, etc. for a particular period cycle.

For example,

LIFO Liquidation Example 1

Inventory during each year is a LIFO layer.

#2 – LIFO Reserve

This is the difference between inventory calculated by methods other than LIFO and the inventory calculated as per LIFO. Sometimes, companies follow more than methods of inventory management for different types of stocks. LIFO is majorly used for reporting purposes. Hence there is a difference between actual inventory and LIFO inventory, which is known as LIFO reserveLIFO ReserveLIFO reserve is the difference between the company’s ending inventory under FIFO accounting and its corresponding value under LIFO accounting. Companies with the LIFO method must disclose this reserve to adjust the LIFO cost of goods sold and closing inventory to their FIFO equivalent values, making it comparable.read more.

#3 – LIFO Inventory Pool

While LIFO liquidation, inventory may be segregated and pooled together with similar other items (forming groups of items) for better and more realistic calculation. Each group is called a LIFO Inventory Pool.

Advantages

Disadvantages

Limitations of LIFO Liquidation and Other Similar Techniques

The calculation of profits from pure LIFO liquidation techniques may be misleading towards actual income calculation.

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 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 existing value based on current cost prices).

With this method of calculation, profits that are derived are more practical and realistic.

Important Points

  • LIFO liquidation is beneficial when the company has a bullish view of the costs of inventory. In other cases, the company may foresee an increase in sales.
  • It may be forecasted. In such a case, if the raw materials costs are predicted to rise, the company can stock up its raw materials gradually at lower costs and then liquidate later, thus booking higher profits.
  • It may be beneficial for short term profits. However, it may not be practical to be used permanently.
  • In general use of this practice (without any planned liquidation), the market may perceive this as the company’s shortfall in funds or lack of analysis of sales, or even financial threats for the company.

Conclusion

Following LIFO liquidation may be tempting to distort the financial statements and evade taxes, in comparison to FIFO inventoryFIFO InventoryUnder the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost.read more; however, it is not treated as the best practice bylaws. There have been various discussions to amend laws around such liquidation so that companies follow more ethical approaches of reporting.

It may be tweaked a little in the form of other similar techniques to give more meaningful data, which can also help in better reporting of financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc.read more for the company.

Recommended Articles

This has been a guide to what is LIFO liquidation and its definition. Here we discuss LIFO Liquidation examples along with its effect on financial statements, advantages, and disadvantages.  You can learn more about accounting from the following articles –

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