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 When a sufficient number of units have been withdrawn from stock to eliminate an entire cost layer, this is termed a LIFO liquidation.

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.