Before we discuss LIFO liquidation, lets review how LIFO works in relation with economy which can either be inflationary (period of rising prices) or deflationary (period of declining prices).
According to Last-in, First-out cost flow assumption the latest inventory in the store will be applied for production and if there is inflationary economy in place then the new inventory bought will have higher prices as compared to the older inventory. In these circumstances, inventory with high price will be accounted for in cost of goods sold (COGS) whereas old inventory which is relatively cheaper will stay in store. Because of this COGS will be higher and value of ending inventory will be lower and both of these effects will result in overall lower profits.
However, things will be completely different if (keeping other things constant especially economy with inflation) entity starts consuming stock or inventory at a rate higher then the rate of purchase or in other words if sales in a particular period are higher then the goods purchased in the same period. Because of this entity will dive into the old and relatively “cheaper” inventory. This is called LIFO liquidation.
In simple words LIFO liquidation means “liquidating” old inventory (which was bought at the price lesser then current replacement price and valued using LIFO inventory valuation method) either by selling or consuming.
Effects of LIFO liquidation
As entity dips into old “LIFO-based” inventory, cost of goods sold will decrease and in the period of rising prices sales prices are high which means that same old inventory which was bought for less will be sold for higher prices. Both of these effects will cause the profits to increase out of no reason. And all this happened only because such stock is used which was valued at, most probably, outdated prices. However, the effect of decreasing COGS and increasing profits are aftermaths of LIFO liquidation whereas LIFO liquidation is simply liquidation of old inventory which was maintained under LIFO method.
This phenomena is considered to be one of the greatest drawbacks of LIFO inventory valuation method as it can distort the accounting and financial records so drastically which may materially affect users of financial statements.