What is a LIFO Liquidation?

A LIFO liquidation occurs when an organization using the last in, first out concept to track its inventory costs uses up its oldest inventory layer. Under the LIFO method, the cost of the last inventory acquired is assigned to the first inventory used. This results in layers of costs in the LIFO database, each one related to the purchase of inventory on earlier dates. When a sufficient number of units have been withdrawn from stock to eliminate an entire cost layer, this is termed a LIFO liquidation.

Example of LIFO Liquidation

Electron Corporation uses the LIFO inventory method for accounting. It has been purchasing computer components for its business. Due to increased sales or reduced purchasing, Electron dips into its older inventory layers, resulting in a LIFO liquidation event.

On January 1, the company purchased 1,000 chips at $10 each, followed by another 1,000 chips on February 1 at $12 each, and then another 1,000 chips on March 1 at $15 each. On March 2, Electron sells 2,500 of these chips. Electron’s accountant uses the following steps to determine the company’s cost of goods sold:

Determine sales impact on inventory layers:
Under LIFO, the latest purchases are sold first. For 2,500 units sold:

First, 1,000 units from the March 1 layer (latest) at $15 each.
Next, 1,000 units from the February 1 layer at $12 each.
Finally, 500 units from the January 1 layer at $10 each.

Calculate the cost of goods sold:

$15,000+$12,000+$5,000 = $32,000

LIFO Liquidation impact:

Before this sale, the January 1 layer had not been touched in previous periods.
The sale forced Electron to use its older inventory (January 1), which costs less than more recent purchases.
This resulted in a LIFO liquidation, causing the company to recognize higher profits because the older, lower-cost inventory is being matched against current sales prices.

Summary of remaining inventory:
After selling 2,500 units:

500 units remain from the January 1 layer at $10 each.
Total remaining inventory value = $10 x 500 units = $5,000

Why a LIFO Liquidation Occurs

A LIFO liquidation occurs when the amount of units sold exceeds the number of replacement units added to stock, thereby thinning the number of cost layers in the LIFO database. This situation can arise when management decides to retain fewer units on hand, perhaps due to a cash flow crunch. This situation can also arise when an unexpected surge in demand wipes out a large part of a firm’s inventory reserves.

Impact of a LIFO Liquidation

In an inflationary environment, when goods are sold and a LIFO liquidation results, the current price at which the goods are sold is matched against the presumably lower cost of goods from an earlier period, which results in the highest possible taxable income for the seller.