Definition of LIFO Liquidation: The erosion of the LIFO inventory is referred to as LIFO liquidation. Erosion means the unavailability or shortage of raw materials or other inputs that enforces companies to use its existing assets. LIFO liquidation leads to distortion of net income and substantial tax payments.
Example: To understand the LIFO liquidation problem assume that XYZ company has 30,000 ponds of steel in its inventory on December 31, 2004. Costed on a traditional LIFO approach. Ending Inventory 2004 Ponds Unit Cost LIFO Cost 2001 8,000 $4 $32,000 2002 10,000 6 60,000 2003 7,000 9 63,000 2004 5,000 10 50,000 --------------- ------------------ 30,000 $205,000 ------------------ -------------------- To alleviate the LIFO liquidation problems and to simplify the accounting, goods can be combined into pools. A pool is defined as a group of items of a similar nature. Thus, instead of only identical units, a number of similar units or products are combined and accounted for together. This method is referred to as the specific goods pooled LIFO approach. With the specific goods pooled LIFO approach, LIFO liquidations are less likely to happen because the reduction of one quantity in the pool may be offset by an increase in another. The specific goods pooled LIFO approach eliminates some of the disadvantages of the specific goods (traditional) accounting for LIFO inventories. This pooled approach, using quantities as its measurement basis, however, creates other problems. First most companies are continually changing the mix of their products, materials, and production methods. A business once engaged in manufacturing train locomotives may now be involved in the automobiler or aircraft business. A business that had used cotton fabric in its clothing now uses synthetic fabric (Dacron, nylon, etc.). If a pooled approach using quantities is employed, such changes mean that the pools must be continually redefined. This can be time consuming and costly. Second, even when such an approach is practical, an erosion (LIFO liquidation) of the layers often results, and much of the LIFO costing benefit is lost. An erosion of the layers results because specific good or material in the pool may be replaced by another good or material either temporarily or permanently. This replacement may occur for competitive reasons or simply because a shortage of a certain material exists. Whatever the reason, the new item may not be similar enough to be treated as part of the old pool. Therefore any inflationary profit deferred on the old goods may have to be recognized as the old goods are replaced. |