Home page               Download material                Accounting topics                Accounting dictionary                Financial calculators

Home Valuation of Inventories LIFO Liquidation
 
 

LIFO Liquidation:
(An Issue Related to LIFO Inventory Valuation Method):

Learning objectives of this article:

  1. Define and explain the term "LIFO Liquidation".


Definition of LIFO Liquidation:

The erosion of the LIFO inventory is referred to as LIFO liquidation. Erosion means the unavailability or shortage of raw materials or other inputs that enforces companies to use its existing assets. LIFO liquidation leads to distortion of net income and substantial tax payments.

Example:

To understand the LIFO liquidation problem assume that XYZ company has 30,000 ponds of steel in its inventory on December 31, 2004. Costed on a traditional LIFO approach.

Ending Inventory 2004
  Ponds Unit Cost LIFO Cost
2001 8,000 $4 $32,000
2002 10,000 6 60,000
2003 7,000 9 63,000
2004 5,000 10 50,000
 
 
  30,000   $205,000
 
 

The ending 2004 inventory comprises costs from past periods. These costs are called layers (increase from period to period). The first layer is identified as the base layer. The layers for XYZ are shown below:

2004
Layer
$50,000
(5,000 10)
2003
Layer
$63,000
(7,000 9)
2002
Layer
$60,000
(10,000 6)
2001
Base Layer
$32,000
(8,000 4)

The price of steel has increased over the 4 year period. In 2005, the company experienced a metal shortages and had to liquidate much of its inventory (a LIFO liquidation). At the end of 2005, only 6,000 ponds of steel remained in inventory. Because the company is using LIFO, the most recent layer, 2004, is liquidated first, followed by the 2003 layer and so on.

As a result the costs from preceding periods are matched against sales revenues reported in current dollars. This leads to a distortion in net income and a substantial tax bill in the current period. These effects are shown below:

LIFO Liquidation

To alleviate the LIFO liquidation problems and to simplify the accounting, goods can be combined into pools. A pool is defined as a group of items of a similar nature. Thus, instead of only identical units, a number of similar units or products are combined and accounted for together. This method is referred to as the specific goods pooled LIFO approach. With the specific goods pooled LIFO approach, LIFO liquidations are less likely to happen because the reduction of one quantity in the pool may be offset by an increase in another.

The specific goods pooled LIFO approach eliminates some of the disadvantages of the specific goods (traditional) accounting for LIFO inventories. This pooled approach, using quantities as its measurement basis, however, creates other problems.

First most companies are continually changing the mix of their products, materials, and production methods. A business once engaged in manufacturing train locomotives may now be involved in the automobiler or aircraft business. A business that had used cotton fabric in its clothing now uses synthetic fabric (dacron, nylon, etc.). If a pooled approach using quantities is employed, such changes mean that the pools must be continually redefined. This can be time consuming and costly.

Second, even when such an approach is practical, an erosion (LIFO liquidation) of the layers often results, and much of the LIFO costing benefit is lost. An erosion of the layers results because specific good or material in the pool may be replaced by another good or material either temporarily or permanently. This replacement may occur for competitive reasons or simply because a shortage of a certain material exists. Whatever the reason, the new item may not be similar enough to be treated as part of the old pool. Therefore any inflationary profit deferred on the old goods may have to be recognized as the old goods are replaced.

Relevant Articles:

Classification of Inventory

Difference between Perpetual and Periodic Inventory System
Basic Issues in Inventory Valuation
Average Cost Method
First In First Out (FIFO) Method
Last In First Out (LIFO) Method
LIFO Reserve
LIFO Liquidation
Basis for Selection of Inventory Method

 

 

A D V E R T I S E M E N T

 

Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
----------------------------------------------------------------------------
  Analysis of Business Transactions
----------------------------------------------------------------------------
  Journal, Ledger and Trial Balance
----------------------------------------------------------------------------
  Accounting for Bills of Exchange
----------------------------------------------------------------------------
  Special Journals
----------------------------------------------------------------------------
  Cash Book
----------------------------------------------------------------------------
Bank Reconciliation Statement
----------------------------------------------------------------------------
  Final Accounts
----------------------------------------------------------------------------
  Work Sheet
----------------------------------------------------------------------------
  Capital and Revenue Items
----------------------------------------------------------------------------
  Valuation of Inventories
----------------------------------------------------------------------------
  Accounts of Non-profit Making Organizations
----------------------------------------------------------------------------
  Statement of Cash Flows
----------------------------------------------------------------------------
  Accounting Ratios Analysis
----------------------------------------------------------------------------
  Depreciation, Provisions and Reserves
----------------------------------------------------------------------------
  Accounting Dictionary
----------------------------------------------------------------------------
  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
----------------------------------------------------------------------------
  Cost Volume Profit Relationship
----------------------------------------------------------------------------
  Variable Costing System
----------------------------------------------------------------------------
  Materials and Inventory Cost Control
----------------------------------------------------------------------------
  Activity Based Costing System
----------------------------------------------------------------------------
  Standard Costing and Variance Analysis
----------------------------------------------------------------------------
  Balanced Scorecard
----------------------------------------------------------------------------
  Capital Investment Analysis/Capital Budgeting
 

 

 

Home                         Download material                         Contact us                         Privacy policy                         Link to us                         Advertise

Copyright 2011