What is LIFO Liquidation?

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.

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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. ABC will have to liquidate a complete April inventory of 120 units, a March inventory of 90 units, and 40 units from the February inventory to complete the order.

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

Based on the sales, consider each shirt is sold for $20.00, and the revenue generated is $5,000.00. However, the cost of raw materials 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 calculations:

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 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,

Inventory during each year is a LIFO layer.

#2 – LIFO Reserve

LIFO is majorly used for reporting purposes. It is the difference between inventory calculated by methods other than LIFO and the inventory calculated per LIFO. Sometimes, companies follow more than inventory managementInventory ManagementInventory management in business refers to managing order processing, manufacturing, storage, and selling raw materials and finished goods. It ensures the right type of goods reach the right place in the right quantity at the right time and at the right price. Thus, it maintains the product availability at warehouses, retailers, and distributors.read more methods for different types of stocks. Hence, there is a difference between actual and LIFO inventory, 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

  • An increase in sales may indicate 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.The movement of older inventory refers to the liquidation of older stocks.The LIFO liquidation method is helpful for the movement of perishable items with lesser tax liability in comparison to the FIFO inventory methodFIFO Inventory MethodUnder 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.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.The 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 than the liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more of stocks procured as per requirement.Refers to the company’s lack of analysis on sales and purchaseIt may relate to future financial shortcomings for the company, since liquidation refers to lack of procurement.It may refer to a threat to its product acceptance in the market, so the company may decide to liquidate its existing and old stock before new procurement.It leads to incorrect calculation of income from sales and hence affects all financial statements and ratiosFinancial Statements And RatiosFinancial ratios are indications of a company’s financial performance. There are several forms of financial ratios that indicate the company’s results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more.

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 current value based on current cost prices).

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

Important Points

  • LIFO liquidation is beneficial when the company has a bullish view of inventory costs. 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 compared 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 to reporting.

It may be tweaked a little in the form of other similar techniques to give more meaningful data, which can also help better report 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.

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

  • FIFO vs. LIFOPeriodic Inventory SystemInventory Write-DownEnding Inventory Calculation