Student Question
“Nathan, I’m struggling with the following problem. I understand the principle behind the lower net income. What’s confusing me is the higher LIFO liquidation vs. lower LIFO liquidation.
What constitutes high and low liquidation?
I would assume high liquidation would mean you are burning through older inventory faster thus further reducing NI when prices are falling. However, lower liquidation is the correct answer. Any thoughts?” – James L.
MCQ – High vs Low LIFO Liquidation
Browman values its inventory using last in, first out (LIFO) method. For the current year, the inventory usage exceeded the purchases. Assuming the prices are falling, how will this situation affect net income for the year?
- Net income will be lower due to higher LIFO liquidation
- Net income will be lower due to lower LIFO liquidation (Correct Answer)
- Net income will be higher due to lower LIFO liquidation
- Net income will be higher due to higher LIFO liquidation
Correct answer: (2) If usage of goods exceeds purchases during a period, a situation called LIFO Liquidation can occur. If prices are falling, LIFO liquidation results in lower income levels being reported and likely lower taxes as well.
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Illustration Of LIFO Liquidation
JL Company uses last-in, first out (LIFO) cost flow assumption. At the end of the year 2015, the company has 20,000 units in its inventory. The details are given below:
| Year of purchase | Quantity | Cost |
| Purchased in 2013 @ $10.00 per unit | 4,000 units | 40,000 |
| Purchased in 2014 @ $9.00 per unit | 2,000 units | 18,000 |
| Purchased in 2015 @ $8.00 per unit | 2,000 units | 16,000 |
| Inventory on hand as of December 31, 2015 | 8,000 units | 74,000 |
Assume that the Jenna company needs to use 7,000 units during 2015, therefore, needs to liquidate much of its inventory.
| Year of purchase | Quantity | Cost |
| Purchased in 2015 @ $8.00 per unit | 2,000 units | 16,000 |
| Purchased in 2014 @ $9.00 per unit | 2,000 units | 18,000 |
| Purchased in 2013 @ $10.00 per unit | 3,000 units | 30,000 |
| LIFO Liquidation | 7,000 units | 64,000 |
Analysis Of LIFO Liquidation
Because the company uses LIFO method, the most recent year, 2015, would be liquidated first, followed by 2014 layer and so on. This liquidation would, therefore, result to matching old higher costs (2014-2013) with the current sales prices.
The income statement of JL Company would, therefore, show much lower profits due to lower LIFO liquidation because inventory usage will not only come from 2015 inventory but also from 2014 and 2013 which have a higher cost per unit.
Lower LIFO liquidation means that the profit is lower because the company matched current sales price with old higher costs.
Higher LIFO liquidation means that the profit is higher because the company matched current sales price with old lower costs.
*To easily distinguish lower from higher liquidation, think of LIFO liquidation as converting inventory into cash and define it as the net effect of converting the inventory. The lower the net effect, the lower will be the LIFO liquidation. The higher the net effect, the higher will be the LIFO liquidation.
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More by Nathan
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