LIFO Liquidation

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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)

Examples of LIFO Liquidation

  • Example 1: ABC company has made two purchases of the same product in the last six months. The first purchase was made in May and the second purchase was made in September. ABC company has decided to use the LIFO liquidation method when issuing the product from the warehouse. In this case, when the product is issued, the company will record the issue in the value of the September purchase, and when its quantity runs out, the issue will be recorded in the value of the May purchase.
  • Example 2: XYZ company has made three purchases of the same product in the last 12 months. The first purchase was made in January, the second purchase was made in June and the third purchase was made in November. XYZ company has decided to use the LIFO liquidation method when issuing the product from the warehouse. In this case, when the product is issued, the company will record the issue in the value of the November purchase, and when its quantity runs out, the issue will be recorded in the value of the June purchase and then in the value of the January purchase.

Advantages of LIFO Liquidation

One of the main advantages of using the LIFO liquidation method is that it reduces tax liabilities, since it matches more current costs with more current revenues. Additionally, the LIFO liquidation method has the following advantages:

  • It can better reflect the actual physical flows of goods and materials.
  • It can reduce the amount of inventory reported on the balance sheet.
  • It can provide a better assessment of the current inventory value.
  • It can provide a more accurate reflection of the actual cost of goods sold.
  • It can provide a better reflection of the company's profitability.

Limitations of LIFO Liquidation

One of the major limitations of the LIFO liquidation method is that it does not accurately reflect the physical flow of goods. This method is used to minimize tax liabilities and it does not always provide an accurate view of the company’s financial performance. Below are some of the limitations of the LIFO liquidation method:

  • It does not accurately reflect the physical flow of goods, as the most recently purchased inventory is assumed to be the first units sold.
  • It is not compliant with the generally accepted accounting principles (GAAP) as it does not match the associated costs with the actual revenues earned.
  • It can lead to inaccurate inventory valuation as it does not consider the actual costs of the inventory.
  • The method does not provide a reliable measure of the company’s financial performance.
  • It does not provide a clear picture of the company’s financial performance as the reported profits can be overstated or understated depending on the inventory valuation.
  • It can lead to distortion of the company’s financial statements, as the income and expenses are recorded in different periods.

Other approaches related to LIFO Liquidation

One other approach related to LIFO Liquidation is the Weighted Average Method (WAM). WAM is a cost-flow assumption that assigns the cost of a good to the inventory based on the weighted average of the costs of all goods acquired over a period of time. This approach is suitable when the company’s inventory is composed of several parts that have been acquired over a period of time, and the costs of these parts are not uniform. The following are the other approaches related to LIFO Liquidation:

  • Dollar Value LIFO (DVL) Method - this approach is similar to the LIFO Liquidation method, however, it is based on the dollar value of the inventory rather than the physical units. This approach is used when the prices of the inventory items are changing frequently.
  • Last Period (LP) Method - this costing method assumes that the cost of the inventory is equal to the cost of the most recently acquired inventory.
  • Specific Identification Method (SIM) - this approach assigns a unique number to each item of inventory and records the cost of each item separately. This method is used when a company has a large inventory and needs to keep track of the cost of each item.

In summary, there are several approaches related to LIFO Liquidation, such as Dollar Value LIFO, Last Period and Specific Identification Method. Each of these methods is suitable for different types of inventory and cost-flow assumptions.


LIFO Liquidation — recommended articles
Opening stock — Closing stock — Accrual method — LIFO Reserve — Underapplied Overhead — LIFO method — Annual depreciation — Inventory value — Adjusted ebitda

References

Author: Maksymilian Piaskowski

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