An accounting method widely used in the business world where the material that was most recently acquired or "last in" is used first.
The LIFO liquidation method is an accounting method widely used in the business world. Companies that keep inventories must have a system in place to monitor them when the manufacturing or sales departments require material from inventory.
They can choose between the most recently purchased supply and the supply that has been in inventory the most.
According to the "last in, first out" (LIFO) strategy, the material that was most recently acquired or "last in" is used first. "First in, first out," or FIFO, is the other primary approach utilized in business.
As needed, it takes the oldest or "first in" content. A firm's handling of its inventory affects earnings and taxes when it liquidates some of it.
This liquidation can affect a company's net operating income, resulting in increased taxable income. When selling inventory products, a corporation uses the most recent expenses under LIFO.
The fewer purchases or things generated, the deeper the corporation digs into its older inventory.
The practice of selling goods beyond the most recent purchase is called liquidation. As the corporation moves deeper into its LIFO layers, it begins to sell its earlier, lower-cost inventory stocks.
The technique lowers the cost of goods sold, increasing gross profits and generating more money to be taxed.
Companies must store materials for future production or sales. Companies acquire in quantity and either sell or use it in continuous production. They keep material that is no longer needed on the books as inventory.
The stuff most recently placed in inventory is used first under LIFO. Companies frequently position recently purchased commodities towards the front of the warehouse and use such goods first.
Older material gathers at the back of the warehouse using this strategy. This method may result in inaccurate values and skews the financial results.
Why is LIFO liquidation utilized?
When current sales exceed purchases, a LIFO liquidation occurs, liquidating any inventory that was not sold in the prior period.
LIFO compares the most recent costs to the most recent revenues. During periods of inflation, when the cost of purchasing goods rises over time, several businesses employ the LIFO approach.
The LIFO approach offers tax advantages because the greater expenses connected with new inventory appear to offset earnings, resulting in a smaller tax burden.
This liquidation occurs for various reasons, including
- The corporation experienced an unexpected cash flow difficulty.
- A sudden increase in interest in the company's products.
- The necessity to move or dispose of inventory is probably because there is a requirement for storage room for newer or more products that meet market demands.
Ultimately, businesses are unwilling to match the older inventory's lower cost of goods with the new inventory's higher sales pricing. It creates better gross margins and earnings than competitors, generating more income tax.
Such a preference motivates management to minimize these liquidations or, at the very least, to manage them wisely when they occur.
When profits are minimal, or management attempts to keep their inventories at low levels, LIFO liquidation is frequently implemented.
While unplanned inventory liquidation because of unexpected circumstances is one potential, management can manipulate corporate earnings using LIFO inventory distortions.
If management desires lesser earnings, it can arrange for repeated acquisitions of fresh material, boosting the potential profit in older, low-cost inventory while keeping costs high.
When management demands a bigger profit, it stops making new purchases of inventory material and instead uses older, lower-cost stock in this liquidation.
Keywords Used in LIFO Liquidation
The LIFO strategy is an economic strategy in which a company first sells its most freshly purchased items. The LIFO approach compares the most recent expenses to the most recent income.
When the cost of purchasing items rises, several firms use the LIFO technique. Due to lower taxation, the higher costs of new inventory seem to balance the higher earnings under the LIFO system.
We need to know the following definitions of this liquidation terminology to understand the rationale behind the LIFO system.
Inventory segregation regularly to calculate closing stocks. This word specifies the number of units, cost per unit, total cost of inventory, and so on for a specific period cycle.
|Year||No. of units||Cost per unit||Total cost|
Each year's inventory is a LIFO layer.
LIFO is mostly used for reporting. It is the differential between inventory computed using non-LIFO methods and inventory calculated using LIFO methods.
Companies can use more than one inventory management strategy for different stocks. As a result, there is a gap between real and LIFO inventory, known as the LIFO reserve.
Companies occasionally use different inventory valuation methodologies for different stocks, and LIFO is mostly used for reporting.
As a result, the LIFO reserve is always the difference between the actual inventory value and the inventory computed by the LIFO method.
Inventory can be separated and pooled like other things during this liquidation for a more accurate and realistic estimate. Each group is referred to as a LIFO Inventory Pool.
During this liquidation, inventory can be separated and grouped with comparable things, forming a group of products. This results in more accurate and realistic computations. The LIFO inventory pool refers to each group that is formed.
LIFO Liquidation Implications
The primary consequence of LIFO Liquidation is to increase the company's earnings during the affected period.
This may seem positive on the surface, but the corporation needs to pay higher taxes as a result, which they could have bypassed if they had the required raw material stock at the going market rate.
Due to increased profitability, more taxes must be paid on income, which may require appropriating a fair portion of the company's profit.
Increased sales could imply increased demand for the company's manufactured goods. Better than FIFO liquidation since the tax burden is reduced due to the higher cost of the most recent inventory.
The liquidation of older stockpiles is referred to as the movement of older inventory.
Compared to the FIFO inventory system, the LIFO liquidation method is useful for transferring fresh produce with minimal tax responsibility.
Advantages and Disadvantages
The advantages of applying the this liquidation could be as follow:
- Aids the company's decision to launch a new product in response to market demands and changes in customer taste.
- A previous projection of an increase in potential sales may cause companies to stockpile needed raw materials at reduced costs to liquidate them later when raw material prices rise.
- When the cost of raw materials is dynamic and expected to increase in the future, the LIFO inventory control approach is helpful.
- An increase in sales indicates a greater demand for the company's product.
- Older stocks are liquidated with the use of LIFO liquidation.
- It is preferable for the quick movement of perishable commodities. The most recent inventory is moved first to meet the needs of changing consumer wants and tastes.
On the other hand, Some of the downsides can be summed by:
- Higher tax liability than liquidating stocks purchased as needed. Refers to the company's absence of sales and purchasing analysis.
- Because liquidation relates to a lack of procurement, it may be related to the company's future financial issues.
- It may allude to a threat to the market acceptance of its goods, in which case the corporation may opt to liquidate its current and old shares before acquiring new stock.
- It results in inaccurate income from sales calculations, which impacts all financial statements and ratios.
- Profits calculated using pure LIFO liquidation procedures may be misleading when calculating actual income.
- Older inventory stacked up in the warehouse may result in an erroneous valuation of the products at the time of sale.
- The corporation continues to buy new materials at greater prices while stocking old resources bought at lower prices. And when the most recent stock of material is consumed first, it signifies that the most expensive material takes precedence, while the old supply remains supplied. It will raise the final cost of the goods.
For inventory disposal, several businesses employ the dollar-value LIFO approach. This procedure begins by first discounting the inventory's current value to the base layer following the current inflation rate.
The real dollar gain is then calculated and amplified to reach the current worth of inventory. Profits are more reasonable and realistic when calculated using this method.
LIFO Liquidation Scenarios
Scenario one: XYZ Company manufactures blankets and has the textile inventory listed below based on periodic cycles:
|Month||Raw Materials||Cost per Unit||Total Cost|
Suppose XYZ company has to complete an order of 200 blankets. You need one unit of raw material to produce one unit of product.
XYZ will have to liquidate a complete March inventory of 100 units, a February inventory of 80 units, and 20 units from the January inventory to complete the order.
LIFO Liquidation means that the last item in stock is the first to go, followed by the next layer based on demand.
Consider that each blanket sells for $20.00, and the profits are $4,000.00. On the other hand, the cost of raw materials is determined as follows:
|100||100 * 16 = 1600|
|80||80 * 14 = 1120|
|20||20 * 12 = 240|
Net income generated = 4000 - 2960 = 1040
If the raw materials are supplied from the march inventory, the total cost will be 200 * 16 = 3200.
And then, the net income will be 800, and the company would report a lower net income.
Scenario two: The Omega company uses the last-in, first-out (LIFO) cost flow assumption. At the end of 2022, the company had 30,000 meters of iron in its inventory. The details are below:
|Year||Cost per Meter||Quantity||Total Cost|
Inventory on 31 December 2022 equals 289000, for 30000 meters of iron.
It is worth noting that the overall inventory cost at the end of 2022 includes costs incurred in 2022, 2021, 2020, and 2019. These expenses are known as layers of LIFO inventory or simply LIFO layers.
The Omega company's LIFO layers are below:
|2019||8 * 12000 = 96000|
|2020||10 * 8000 = 80000|
|2021||11 * 7000 = 77000|
|2022||12 * 3000 = 36000|
Assume that in 2023, Omega Company needs to utilize 28,000 meters of iron, but due to a shortage, the company is forced to sell off a large portion of its old iron inventory.
The corporation uses a LIFO approach; thus, the layer that was most recently added, layer 2022, would be liquidated first, then layer 2021, and so on.
This liquidation would compel the corporation to reconcile its previous cheap costs with its current higher sales pricing. Omega's income statement would thus reflect significantly higher profits, resulting in a bigger tax burden in the present quarter.
With the remaining 2000 metals in the inventory, the total cost of goods sold will be equal to
(3000 * 12) + (7000 * 11) + (8000 * 10) + (10000 * 8) = 273000.
- LIFO liquidation is advantageous when a company's inventory costs are expected to rise. In such circumstances, the corporation may anticipate a rise in revenue.
- It may be predicted. If raw material costs are expected to grow, the corporation can stock up on raw materials progressively at reduced costs and then dispose of them later, resulting in larger profits.
- It may be helpful for short-term gains. Yet the usage of it permanently might not be feasible, though.
- In the absence of any scheduled liquidation, the market may interpret this behavior as the company's lack of finances, sales analysis, or even financial risks to the company.
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Researched and authored by Hala Kiwan | LinkedIn
Reviewed and edited by Parul Gupta | LinkedIn
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