What Is LIFO Liquidation, How It Works, Example

This term provides the number of units, cost/unit, the total cost of inventory, etc., for a particular period cycle. Using LIFO, this means that the 500,000 units purchased in 2020 would be accounted for first with a cost of goods sold of $5,500,000, revenue of $10,000,000, and a gross profit of $4,500,000. As we use LIFO, the cost of goods sold will depend on latest price which we bought from the supplier. As we use LIFO, the cost of goods sold will exceed the latest price which we bought from the supplier. The cost of 2,000 units sold will base on the current price and another 1,000 units base on the previous price.

  • Firms need to maintain proper documentation and follow specific procedures in order to accurately record inventory costs using this method.
  • Sometimes a business might use multiple inventory valuation methods.
  • Average cost method, which is a middle ground between FIFO and LIFO, uses a weighted average of all units available for sale during the accounting period to determine COGS and ending inventory values.
  • The net income in the LIFO method is lower as the latest inventory has a higher cost.
  • The choice of inventory method may depend on factors other than tax implications or financial reporting requirements.
  • When a company is using the LIFO method for its inventory valuation, inventory from varying financial periods is categorized.

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This situation can arise when management decides to retain fewer units on hand, perhaps due to a cash flow crunch. This situation can also arise when an unexpected surge in demand wipes out a large part of a firm’s inventory reserves. Because the company employs a LIFO method, the most recent layer, 2022, would be liquidated first, followed by 2021 layer and so on. This liquidation would enforce the company to match old low costs with the current higher sales prices. The income statement of Delta would, therefore, show much higher profits that would eventually lead to higher tax bill in the current period. LIFO liquidation causes distortion of net operating income and may become a reason of a higher tax bill in current period.

LIFO Liquidation

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. Can Last In, First Out (LIFO) Be Used in Periods of Falling Prices? Although LIFO is most commonly used during periods of rising prices, it can also be employed when prices are falling, although the impact on net income would be different. The choice of inventory cost flow method depends on a company’s unique circumstances and objectives. Industries that frequently use LIFO include retailers and auto dealerships, which typically have large inventories.

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However, lower net income under LIFO can impact financial performance metrics like EPS (Earnings Per Share) and ROE (Return on Equity). Last In, First Out (LIFO), as a method for inventory accounting, has significant implications for net income and taxes. By recording the most recently purchased or produced items as sold first, LIFO lowers net income due to higher cost of goods sold (COGS).

When it comes to adherence to accounting standards, companies utilizing LIFO must ensure they comply with GAAP regulations. Firms need to maintain proper documentation and follow specific procedures in order to accurately record inventory costs using this method. This level of compliance can add complexity and cost for these organizations, which shareholders and analysts should be aware of.

How a LIFO Liquidation Works

The liquidation occurs when a company using LIFO wants to get rid of old and perhaps obsolete inventory quickly. Thus, a cost to using the LIFO liquidation method is higher tax liability if prices have risen since LIFO was adopted. The expected tax advantage of LIFO turns into a disadvantage because older, lower costs (of older inventory) are matched with current revenues. Industries that typically use LIFO include retailers, automobile dealerships, and other businesses with substantial inventories, as they can take advantage of tax savings during periods of price inflation.

As a result, any inventory not sold in previous periods must be liquidated. In periods of rising prices, the lower net income under LIFO can be beneficial for taxes since lower taxable income translates to less tax payable. Additionally, companies using LIFO might have fewer inventory write-downs during inflationary periods as the most recent costs are expensed as COGS even if they may be higher than older inventory costs. Last In, First Out (LIFO) is a popular inventory accounting method used predominantly in the United States to account for inventory. This method follows the principle of recording the most recently produced or purchased items as sold first.

LIFO and Financial Reporting: Implications for Shareholders and Analysts

As the months proceed, there is a sudden increase in the demand for the product. 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. The impact of LIFO Liquidation might not be hurtful on the business operations.

How a LIFO Liquidation Works

  • To summarize, the Last In, First Out (LIFO) method is an essential inventory accounting technique used in the United States.
  • Under LIFO, a company uses the most recent costs when selling inventory items.
  • LIFO, Last-in First-Out, is the method that we use to calculate the cost of goods sold based on the recent cost of inventory.
  • However, it can also present disadvantages, like a potential understatement of inventory values and lower reported net income.
  • However, this results in lower reported net income and earnings per share (EPS).

In periods of rising prices, FIFO may not accurately represent the lifo liquidation true cost of goods sold as it does not account for the decline in value due to inflation. In contrast, LIFO provides a more accurate reflection of the current cost of inventory as it assumes that the most recently acquired items are sold first. In the three years from 2017 to 2019, it purchased 750,000 units of product A every year to sell at a price of $20 each. The suppliers may increase the price of inventory due to various reasons which will impact our cost.

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