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.
Each method has its merits and demerits. LIFO method implies that the inventory purchased in most recent times is used first, and the older inventory stays in.
The LIFO method is used by most companies when there is higher inflation. As a result, the company tries to match the cost of goods sold with the market prices.
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.
What is LIFO Liquidation?
LIFO liquidation is a corresponding concept of the LIFO method.
In this article, we’re going to understand the concept of LIFO Liquidation. You will be walked through the reasons why the company uses LIFO liquidation, its process, example, merits, and demerits.
LIFO Liquidation
LIFO liquidation can be defined as,
The process of selling the older merchandise stock or issuing older raw material inventory to the manufacturing department is called LIFO Liquidation.
LIFO Liquidation most commonly occurs when the company sells more items than it has purchased.
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.
LIFO liquidation helps the company to get rid of the older stock. But at the same time, there are some consequences a business organization has to accept as a result.
In the following sections, we’ll debug why and when does LIFO Liquidation occurs.
When Does LIFO Liquidation Occur?
Many incidents, economic events, and managerial decisions lead to LIFO Liquidation for any business. The most common reasons for LIFO liquidation are:
- A company might face an unexpected cash flow shortage.
- New inventory is short due for any reason. For instance, under-estimation of expected demand, inability to buy or issue the stock, or cash flow problems
- Market demand has suddenly increased, resulting in more than expected sales. Consequently, the business has to sell its older inventory too.
- The management decides to get rid of the older and obsolete inventory. The older inventory is incurring regular carrying costs; therefore, the business sold out the old stock at discount. It creates rooms for the latest stock and supplies.
Breaking Down LIFO Liquidation
Let’s break down the concept of LIFO Liquidation to have a better understanding.
In terms of accounting, the older stockpiles in the company’s inventory are often called layers. Since the company buys new inventory in every financial period, the old inventory stacks up. This happens most commonly in businesses that use the LIFO method.
When there is a spike in the market demand or any other particular event, the older stock is consumed. This delayering is often termed as LIFO Liquidation.
The impact of LIFO Liquidation might not be hurtful on the business operations. But, it has an impactful consequence on the financial statements indeed. You might have seen something while going through any company’s financial statements.
Any business stating about LIFO Liquidation in SEC filing will have higher net income due to lower COGS. As a result, they are exposed to higher corporate tax.
This is just the opposite of the LIFO Method. Because the companies save tax expenses by using the LIFO method.
Some terms are important to understand for comprehending the concept of LIFO Liquidation.
LIFO Layer
When a company is using the LIFO method for its inventory valuation, inventory from varying financial periods is categorized.
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.
LIFO Reserve
Sometimes a business might use multiple inventory valuation methods. LIFO Reserve refers to the difference between the inventory under the LIFO method and the inventory calculated using other methods.
Most companies use LIFO for only reporting purposes to achieve tax savings. Therefore, calculating LIFO reserves is a common practice.
LIFO Inventory Pool
Some of the experts and managerial gurus suggest LIFO Inventory Pool prevents the impact of LIFO Liquidation on the net income. It refers to pooling up different products or items. The lower cost of older inventory is offset by the high cost of another item in combination.
Example
Here is a numerical illustration of how LIFO Liquidation works in any business.
Macrons & Macrons is a consumer product company and uses the LIFO method of inventory valuation. Over 3 years, they have purchased 1.5 million items per year. The cost per unit was $9 in year 1, $12 in year 2, and $15 in year 3. The sale price every year was $50.
The company managed to sell 1,000,000 units in every subsequent year. At the end of year 3, the company had 1.5 million units in its inventory stock.
In the fourth year, the company anticipated that year 4 sales will also remain around 800000 units—the management order 1 million units for year 4 at $18 per unit.
| Year of Purchase | Cost Per Unit | Quantity | Total Cost |
| 1 | $9 | 1,500,000 | $13500000 |
| 2 | $12 | 1,500,000 | $18000000 |
| 3 | $15 | 1,500,000 | $22500000 |
| 4 | $18 | 1,000,000 | $18000000 |
As the months proceed, there is a sudden increase in the demand for the product. The total sales for year 4 are $1,700,000 units.
Since the company follows LIFO Method, 1 million units will be priced at the latest inventory. The COGS for 1 million units will be $18 million.
The revenue generation amounted to $50 million. The remaining 7 lac of the units will be taken from year 3 and year 2. The units from year 3 will be 500,000, and COGS will be $7.5 million. The revenues will be $25 million.
200000 units are taken from year 2. The COGS will be $2.4 million, and revenue generation will be $10 million.
| Year of Purchase | Quantity Sold | Quantity Remaining | Cost Per Unit | COGS | Revenues – COGS |
| 4 | 1,000,000 | – | $18 | 18,000,000 | $32,000,000 |
| 3 | 500,000 | – | $15 | 7,500,000 | $17,500,000 |
| 2 | 200,000 | 300,000 | $12 | 2,400,000 | $7,600,000 |
| 1 | – | 500,000 | $9 | – | – |
Merits
Here are some of the merits LIFO Liquidation offers to the business.
- One of the possible reasons for LIFO Liquidation is an increase in market demand. Therefore, this is a positive signal for the company as it signifies an increase in demand for its products.
- LIFO Liquidation is better than FIFO Liquidation. The reason is that tax liability arising from LIFO liquidation is lower than that of FIFO due to a higher amount of recent inventory used.
- The company can get rid of the older stock that is leading to increased carrying costs, storage space issues, and, in some cases, obsoleting.
- If a company deals in perishable goods, LIFO liquidation is very helpful in the outward movement of the products.
- Suppose a company plans to launch a new product design, update a product, or refurbish an old design. In that case, LIFO Liquidation helps in moving out old stocks.
- When there is a prior forecast about the increase in demand for the product in the coming years, LIFO methods help to pile up the stock at lower costs.
Demerits
There are some of the significant implications of LIFO Liquidation.
- When the company is selling out the older stock procured at a lower price, the COGS is very low. As a result, the gross profits for the financial year are overstated. This leads to higher tax liability in the financial period of LIFO Liquidation.
- LIFO liquidation is another indication of the company’s inability to forecast and manage the budget and sales. If the analysis is accurate, there will no need for LIFO Liquidation.
- One potential reason for LIFO Liquidation is the inability to purchase the inventory for the business. Therefore, it can signify the cash flow shortage or other financial shortcomings of the company due to which LIFO Liquidation becomes inevitable.
- Sometimes, launching a new product is due to the unacceptance of the company’s existing product. Before new procurement, the company decides to liquidate old stock. This might pose to be a threat to the company’s product acceptance.
- The financial statements are inaccurately presented due to the LIFO Liquidation. It might give rise to ethical impositions as the financial ratio analysis and financial statements, in general, represent misguiding facts.
How Does It Impact Net Income?
The impact of the LIFO Liquidation on the net income is usually implied by the higher gross profits but lower net income. The lower net income is characterized by, the higher corporate tax liability.
The lower-value stock is sold out, and the cost of goods manufactured and sold is lower than in previous years. It leads to higher gross profit leading to high tax liability.
However, a company can benefit from LIFO Liquidation when the market demand signals bullish trends.
Conclusion
Many companies prefer using LIFO Liquidation as compare to the FIFO Inventory. It might be tempting for the reason of understating income and tax evasions. But it is not a best practice under the ethical norms of doing business.
Many law amendments have been made and are still in place to bound companies’ compliance to more ethical practices. However, using LIFO Liquidation when there is no other better option can save the business from unnecessary hassles.
