LIFO Liquidation Definition, How it Works, Why

Yes, without the proper disclosure and understanding, overreliance on straight line depreciation definition can present an inflated view of a company’s profitability and financial health. There are 2,000 units remaining at the end of the month, and they will value base on the old cost. As we use LIFO, the cost of goods sold will depend on latest price which we bought from the supplier.

But it is not a best practice under the ethical norms of doing business. 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 primary consequence of LIFO Liquidation is to increase the company’s earnings during the affected period. During this liquidation, inventory can be separated and grouped with comparable things, forming a group of products. It is the differential between inventory computed using non-LIFO methods and inventory calculated using LIFO methods.

Efforts to sell older inventory may be a sign of LIFO Liquidation. We can see that the cost of goods sold increase $ 4,000 just after the purchasing price increase, and it will decrease the profit significantly. As we already know, accountants use LIFO to determine the cost of goods sold and inventory valuation, so these two accounts will be impacted by LIFO method when the purchasing price of inventory changes.

  1. We use this method to calculate the cost of inventory sold and the valuation of the remaining stock.
  2. Hence, understanding LIFO liquidation is vital for financial planning and inventory management to avoid unfavorable impacts on businesses’ financial performances.
  3. This could eventually lead to higher taxes and lower profits when the cheaper inventory is exhausted.
  4. The increase in profitability results in more taxes to be paid on the income, and that might take a reasonable appropriation of the profit that the company has made.
  5. The cost of inventory may be decreased due to the market condition, which also impacts our financial statements.

The process provides a lower cost of goods sold (COGS), which increases gross profits, and generates more income to be taxed. ABC Company uses the LIFO method of inventory accounting for its domestic stores. It purchased 1 million units of a product annually for three years. The per-unit cost is $10 in year one, $12 in year two, and $14 in year three, and ABC sells each unit for $50. It sold 500,000 units of the product in each of the first three years, leaving a total of 1.5 million units on hand. Assuming that demand will remain constant, it only purchases 500,000 units in year four at $15 per unit.

Impact of LIFO Inventory Valuation Method on Financial Statements

LIFO Liquidation is typically not seen as a sustainable strategy, as it may result in liquidating older, lower-cost inventory, leaving more expensive inventory in stock. This could eventually lead to higher taxes and lower profits when the cheaper inventory is exhausted. LIFO Liquidation reduces the cost of goods sold and increases the gross margin and net income. This is because the older and cheaper units of inventory are sold off, lowering the overall cost of goods sold. The implications may include a sudden increase in net income due to lower cost of goods sold, taxable income, and the potential distortion of the firm’s financial picture if not properly managed.

What Is LIFO Liquidation, How It Works, Example

Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Almost all analysts look at a publicly-traded company’s LIFO reserve. Often earnings need to be adjusted for changes in the LIFO reserve, as in adjusted EBITDA and some types of adjusted earnings per share (EPS).

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. Companies occasionally use different inventory valuation methodologies for different stocks, and LIFO is mostly used for reporting. When management demands a bigger profit, it stops making new purchases of inventory material and instead uses older, lower-cost stock in this liquidation. During periods of inflation, when the cost of purchasing goods rises over time, several businesses employ the LIFO approach. The technique lowers the cost of goods sold, increasing gross profits and generating more money to be taxed.

In the following example, we will compare it to FIFO (first in first out). 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.

As discussed below, it creates several implications on a company’s financial statements. Last-in First-out (LIFO) is an inventory valuation method based on the assumption that assets produced or acquired last are the first to be expensed. In other words, under the last-in, first-out method, the latest purchased or produced goods are removed and expensed first. Therefore, the old inventory costs remain on the balance sheet while the newest inventory costs are expensed first. Macrons & Macrons is a consumer product company and uses the LIFO method of inventory valuation. The cost per unit was $9 in year 1, $12 in year 2, and $15 in year 3.

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However, it’s a one-off situation and unsustainable because the seemingly high profit cannot be repeated. Therefore, its gross profit from selling out its inventory would be $1,975, or $6,000 in revenue – $4,025 in COGS. This scenario occurs in the 2010 financial statements of ExxonMobil (XOM), which reported $13 billion in inventory based on a LIFO assumption. In the notes to its statements, Exxon disclosed the actual cost to replace its inventory exceeded its LIFO value by $21.3 billion. As you can imagine, under-reporting an asset’s value by $21.3 billion can raise serious questions about LIFO’s validity. Under FIFO, Firm A doesn’t touch any of the inventory it added in Year 6.

Some companies may provide discounts on the old stock to increase sales. During economic downturns, LIFO liquidation could result in higher gross profit than would otherwise be realized. If the LIFO layers of inventory are temporarily depleted and not replaced by the fiscal year-end, LIFO liquidation will occur resulting in unsustainable higher gross profits. Many companies frequently change their sales mix as they grow their business. This approach may prove costly as well as time consuming for such companies because they have to redefine the inventory pools each time a change in mix of their products occurs. The other thing that happens with LIFO is the inventory value as reflected on the balance sheet becomes outdated.

The company wants to get rid of the old inventory before it becomes obsolete or even written off. As we know the inventory will face a high risk of obsolete when they are kept in the warehouse for longer than usual time. When they stay for a certain period of time, they are highly likely to stay forever. 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.

By offsetting sales income with their highest purchase prices, they produce less taxable income on paper. However, the main reason for discontinuing the use of LIFO under IFRS and ASPE is the use of outdated information on the balance sheet. Recall that with the LIFO method, there is a low quality of balance sheet valuation. Therefore, the balance sheet may contain outdated costs that are not relevant to users of financial statements. For example, consider a company with a beginning inventory of two snowmobiles at a unit cost of $50,000. For the sale of one snowmobile, the company will expense the cost of the newer snowmobile – $75,000.

But, it has an impactful consequence on the financial statements indeed. You might have seen something while going through any company’s financial statements. 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 value of its remaining inventory is $1,575 (i.e., old stock from Years 1 and 2). The highlights the incompetency of the organization to predict the demands of their products in the market successfully, and it shows the company to better study their standings in the market. The LIFO Liquidation provides a profit for the short term, and the review of the same is to be done to plan better and not fail the expectation of the consumers.

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