LIFO Liquidation

LIFO Liquidation

LIFO (last-in, first-out) is an inventory-costing method that assumes the most recently acquired inventory is sold first. A LIFO liquidation occurs when a company using LIFO sells more goods than it purchases in a period, forcing older (earlier) inventory layers—often recorded at lower historical costs—to be included in cost of goods sold (COGS). That shift can temporarily boost reported gross profit and taxable income because older, cheaper costs are matched against current (typically higher) revenues.

Key takeaways

• LIFO matches recent costs to current revenues; LIFO liquidation happens when inventory layers are reduced.
• During inflation, liquidating older, lower-cost layers raises gross profit and tax liability.
• LIFO liquidation can distort period-to-period comparability of earnings.
• IFRS does not permit LIFO; it is used mainly under U.S. GAAP.

How LIFO liquidation works

• Under LIFO, COGS is based on the most recent purchase costs.
• If sales exceed purchases, the company draws down older LIFO layers. Those older costs (usually lower in an inflationary environment) are included in COGS.
• Because COGS uses lower historical costs while selling prices reflect current market levels, gross profit and taxable income can spike temporarily.
• Companies can trigger LIFO liquidations unintentionally (due to demand shifts or supply constraints) or intentionally (to report higher earnings), but the resulting higher taxes and reduced inventory levels are trade-offs.

Example

ABC Company purchases 1,000,000 units per year for three years at these per-unit costs:
* Year 1: $10
Year 2: $12
Year 3: $14

ABC sells each unit for $50 and sold 500,000 units in each of the first three years, leaving 1,500,000 units in inventory (older layers remain). In year four ABC purchases only 500,000 units at $15 per unit but sells 1,000,000 units because demand increased.

Under LIFO, year-four sales consume:
* 500,000 units from year 4 at $15 (newest layer)
* Revenue: $25,000,000
* COGS: $7,500,000
* Gross profit: $17,500,000
* 500,000 units from year 3 at $14 (older layer liquidated)
* Revenue: $25,000,000
* COGS: $7,000,000
* Gross profit: $18,000,000

Total year-four revenue = $50,000,000; total COGS = $14,500,000; total gross profit = $35,500,000. The inclusion of the older $14 cost layer (instead of a more recent, higher cost) raises gross profit relative to a situation where all COGS reflected current higher purchase costs.

Why it matters

• Earnings volatility: LIFO liquidations create one-time profit increases that can mislead about ongoing operating performance.
• Tax impact: Higher reported profits from liquidations increase taxable income in the short term.
• Disclosure and analysis: Companies typically disclose LIFO liquidation effects; analysts often adjust results to compare operating performance across periods.
• Accounting environment: Because LIFO is not permitted under IFRS, this phenomenon is primarily relevant for companies reporting under U.S. GAAP.

Bottom line

LIFO liquidation is an accounting outcome of reducing inventory layers under LIFO costing. It can produce a temporary boost to reported profits and taxes by bringing older, lower costs into COGS. Investors and analysts should identify and adjust for LIFO liquidation effects to assess a company’s underlying operating performance.