LIFO Liquidation (Definition, Example) | Effect on the Financial Statements

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 in results of operations.

Example of LIFO Liquidation

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

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 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, revenue generated is $5,000.00. However, the cost of raw material is calculated as below:

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:

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

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 stocks. This term provides the number of units, cost/unit, the total cost of inventory, etc. for a particular period cycle.

For example,

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 reserve.

#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

Increase in sales may be an indication of an increase in demand for the company’s manufactured product.
Better than FIFO liquidation, as tax liability reduces due to the increased cost of the latest inventory.
Movement of older inventory refers to the liquidation of older stocks.
LIFO liquidation method is helpful for the movement of perishable items with lesser tax liability in comparison to the FIFO method.
Aids to the company’s decision to launch a new product as per market demands and change in taste of customers.
Prior forecast of an increase in potential sales may drive companies to pile up required raw materials at lower costs, to liquidate later when raw material prices rise.
LIFO method of inventory system is useful when raw material costs are dynamic and are predicted to rise in the future.

Disadvantages

Higher tax liability in comparison to the liquidation of stocks procured as per requirement.
Refers to the company’s lack of analysis on sales and purchase
May relate to future financial shortcomings for the company, since liquidation refers to lack of procurement as per requirement.
May refer to threat to the company’s product acceptance in the market, which is why the company may decide to liquidate its existing and old stock before fresh procurement.
Leads to incorrect calculation of income from sales and hence affects all financial statements and ratios.

Limitations of LIFO Liquidation and Other Similar Techniques

Calculation of profits from pure LIFO liquidation technique 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 over 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, 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 inventory management; 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 information for the company.