LIFO Liquidation

LIFO Liquidation
See also

LIFO Liquidation (Last-in, First-out) – is a method of inventory valuation based upon the assumption that the most recently purchased goods, materials or products intended for withdrawals are assumed to be the first units sold to customers. According to the LIFO liquidation model, when an item is released from the warehouse, the company records the issue in the value of the last acquired item, and when its quantity runs out, at the unit price of the prior batch of items (H.L. Wright 1976, p. 1). LIFO liquidation method, in contrast to the FIFO liquidation method (First-in, First-out), matches the relatively current costs with the most current revenues. This cost-flow assumption does not usually reflect the actual physical flows of goods, however, this method is especially favourable during periods of inflations as it reduces tax liabilities due to the fact it lowers reported income (thanks to the higher costs of goods sold) (Patrick R. Delaney, O. Ray Whittington 2011).

Stock valuation methods are important due to the fact that prices of purchased materials and general production costs change over time. There is often a situation where the inventory units in stock were received at different prices. When spending stock from a warehouse, the company must decide at what price to post its release. If inventory records are not kept in details, the enterprise is unable to indicate exactly which part of them was accepted at which price. What is known is how much stock was received at a given price. Therefore, enterprises adopt a specific valuation model, such as:

  • Weighted average,
  • First-in, First-out (FIFO) Liquidation,
  • Last-in, First-out (LIFO) Liquidation, which is permitted by U.S. GAAP, however, IFRS prohibits this method.

What is worth noticing is the fact the neither U.S. GAAP nor IFRS obligates companies to use particular identification method; both allow to choose a cost-flow assumption, taking no account of the actual physical flows of goods (C.P. Stickney and others 2010, p. 379).

Differences between LIFO and FIFO

LIFO FIFO
Last-in, First-out – the most recent goods in the inventory are the first to be sold. Fist-in, Fist-out – the earliest goods in the inventory are the first to be sold.
IFRS prohibits using the LIFO method. No restrictions by GAAP or IFRS.
Favourable during high inflation as it increases the cost of goods sold and decreases the net profit. Unfavourable during high inflation as it decreases the cost of goods sold and increases the net profit.
The accounting profit and value of unsold inventory becomes higher during deflation. The accounting profit and value of unsold inventory becomes lower during deflation.
Understates the profit of the current period. Overstates the profit of the current period.
Understates the value of the ending inventory stock. Shows a relatively real value of the ending inventory stock.
Less frequently used. More frequently used.

(Based on C.P. Stickney and others 2010, p. 379-395 as well as D.E. Kieso and other 2011, p. 422-440)

References

Author: Maksymilian Piaskowski