LIFO Liquidation – Best Practices to Solve
LIFO Liquidation – Best Practices to Solve
What is LIFO Liquidation?
LIFO liquidation refers to the practice of selling or issuing of older merchandise stock or materials in a company’s inventory. It is done by companies that are using the LIFO (last in, first out) inventory valuation method. The liquidation occurs when a company using LIFO sells more goods or issues more old stock than it buys.
A Breakdown of LIFO Liquidation
LIFO liquidation can distort a company’s net operating income, which generally leads to more taxable income. In most cases, a company uses the most recent costs when selling inventory items. The fewer the number of purchases made, or items produced, the further the company needs to go into their older inventory.
When they begin selling inventory beyond that most recent purchase, the process is known as liquidation. As the company goes further back into their LIFO layers, they use up their older, lower cost inventory reserves. The process leads the cost of goods sold (COGS) to decrease and makes gross profits rise, which means more income recorded that can be taxed.
Why LIFO Liquidation Occurs
There are a number of reasons why LIFO liquidation occurs, including:
- A sudden cash flow problem within the company
- An unexpected spike in demand for the goods the company sells
- A lack of more recent inventory (either because of failure/inability to buy or an issue with production)
- The need to relocate or get rid of inventory, most likely due to a desire for storage space for newer and/or more goods that fit in with the wants and needs of consumers
At the end of the day, companies are generally unwilling to match the lower costs for goods from their old inventory with the current higher sales prices because, when put head to head, it means the company shows a larger pool of income that the government can take taxes from. The process eats significantly into the company’s profits and may significantly affect its bottom line.
LIFO liquidation is often reserved, typically, for companies that are either in some type of financial crisis or are trying to keep their warehouses clear for goods they anticipate needing to buy in the future.
In most of the cases, companies do not liquidate their LIFO inventory voluntarily. A company may have to liquidate its LIFO inventory due to one or more of the following reasons:
- Shortage of merchandise or materials inventory
- Higher volume of sales than purchases
- A sudden increase in demand for the product
- Shortage of funds
- Need to move the old inventory immediately due to change in taste or fashion
- Need to free up warehouse space etc.
For further explanation of the concept, consider the following example:
The Delta company uses last-in, first-out (LIFO) cost flow assumption. At the end of the year 2012, the company has 20,000 meters of copper coil in its inventory. The details are given below:
Notice that the total cost of inventory at the end of 2012 comprises of the costs incurred in 2012, 2011, 2010, 2009 and 2008. These costs are referred to as ‘layers of LIFO inventory’ or only ‘LIFO layers’. The LIFO layers of Delta company are shown below:
Assume that the Delta company needs to use 18,000 meters of copper coil during 2013 but company experiences a shortage of copper coil and, therefore, needs to liquidate much of its inventory.
Because the company uses LIFO method, the most recent layer, 2012, would be liquidated first, followed by 2011 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 company would, therefore, show much higher profits that would lead to higher tax bill in the current period.
Use of specific goods pooled LIFO approach:
To overcome the problem of LIFO liquidation, some companies adopt an approach known as specific goods pooled LIFO approach. Under this approach, a number of similar products are combined and accounted for together. This combination or group of similar items is referred to as pool. Under this approach, the liquidation of an item in the pool is usually offset by an increase in another item.
Specific goods pooled LIFO approach is not a perfect solution of LIFO liquidation but can eliminate the disadvantages of traditional LIFO inventory system to some extent.
Companies frequently change their sales mix as they grow. This approach may be costly and time consuming for such companies because they have to redefine pools each time a change in the mix of their products is made.
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