What Is a LIFO Liquidation?
Let me explain what a LIFO liquidation is directly to you. It's when a company sells the most recently acquired inventory first, which happens if the company uses the last-in, first-out (LIFO) inventory costing method and ends up liquidating its older LIFO inventory. You see this when current sales exceed purchases, forcing the liquidation of inventory that wasn't sold in previous periods.
Key Takeaways
Here's what you need to grasp about LIFO liquidation. It's when a company sells its newest inventory first. This is part of the accounting method that relies on the last-in, first-out (LIFO) inventory costing approach. LIFO matches the most recent costs against current revenues. Some companies turn to the LIFO method during inflation periods when inventory purchase costs rise over time.
How a LIFO Liquidation Works
Understand that the LIFO method is a financial practice where a company sells the most recent inventory it purchased first. It matches those most recent costs against current revenues. You'll find companies using LIFO during inflation when inventory costs increase. This method gives tax benefits because the higher costs of new inventories offset profits, leading to a lower tax burden.
LIFO Liquidation Example
Take ABC Company, which uses the LIFO method for inventory accounting in its domestic stores. It purchased 1 million units of a product each year for three years. The per-unit cost was $10 in year one, $12 in year two, and $14 in year three, and it sells each unit for $50. It sold 500,000 units in each of the first three years, leaving 1.5 million units on hand. Assuming steady demand, it only buys 500,000 units in year four at $15 per unit.
But demand rose unexpectedly, and ABC sold 1,000,000 units in year four. Under LIFO, it liquidates 500,000 units from year four first, giving revenues of $25 million, COGS of $7.5 million, and gross profits of $17.5 million. Then it liquidates 500,000 units from year three, with revenues of $25 million, COGS of $7 million, and gross profits of $18 million.
Purchase Summary by Year
- Year 1: $10 per unit, 1,000,000 quantity, $10,000,000 total cost
- Year 2: $12 per unit, 1,000,000 quantity, $12,000,000 total cost
- Year 3: $14 per unit, 1,000,000 quantity, $14,000,000 total cost
- Year 4: $15 per unit, 500,000 quantity, $7,500,000 total cost
Liquidation Details in Year 4
- Year 4: 500,000 quantity sold, 0 remaining, $15 cost/unit, $7,500,000 COGS, $17,500,000 gross profit
- Year 3: 500,000 quantity sold, 500,000 remaining, $14 cost/unit, $7,000,000 COGS, $18,000,000 gross profit
- Year 2: 0 quantity sold, 500,000 remaining, $12 cost/unit
- Year 1: 0 quantity sold, 500,000 remaining, $10 cost/unit
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