LIFO Liquidation

Under LIFO method old units based on lower cost remain with the entity and newer units with higher cost are charged to cost of goods sold. These old piles stock or better known as layers in accounting community are usually not consumed as entity keeps on buying newer inventory at newer rates on regular basis. However, if entity is unable to purchase inventory for any reason but consumption continues then old piles will get consumed.



In simple words this “delayering” of old stock occurs if entity’s consumption is more than inflow (purchase or production) of material. This delayering is called LIFO liquidation.

Delayering of old stock is not a problem in itself but the way it effects the financial statements is what causes concerns. While studying LIFO and discussing its advantages we learnt that entities enjoy tax savings under this cost flow assumption. But all of these benefits are reversed if delayering occurs. It is because oldest units are based on lower costs and when they are consumed, cost of sales will be lower as it is based on lower costs which will lead to higher than anticipated profits and entity might have to pay substantially higher taxes.

Example – LIFO Liquidation

FitFoot makes beach sandals. Following is the record of raw material for which entity use LIFO method:

Units$ Rate/unit
Units Brought forward70
100
50
10.0
11.0
10.5
Units Purchased this period20015

If entity has sold 150 units during the period with $25 per unit sale price;

(a) calculate cost of sales and gross profit with data given above
(b) calculate cost of sales and gross profit with data given above assuming no purchases were made during the period.

Solution:

(a) Cost of sales

As entity is using LIFO method therefore cost of 150 units sold will be based on cost of most recent purchases of $15/unit therefore

Cost of sales = 150 x 15 = 2,250
Sales = 150 x 25 = 3,750
Gross profit 1,500

(b) Cost of sales if no purchases were made during the period

In this case cost of 150 units sold will be calculated on the basis of units brought forward only as follows:

  50 units @ $10.50/unit =   525
100 units @ $11.00/unit = 1100
1625

Now we can calculate gross profit:

Sales = 150 x 25 = 3,750
Cost of Sales = as above = 1,625
Gross profit 2,125

It is evident from above example that just because old stock is consumed, gross profit has increased from 1500 to 2125.