Liquidation of LIFO Layer

A liquidation of a LIFO layer occurs when a company that values inventory using last in, first out (LIFO) sells more units in a period than it buys or produces, so that its inventory quantity falls. Under LIFO, each year in which inventory grows adds a new layer at that year's costs. When quantities drop, the most recent layers are used up first, and if the decline is large enough, older layers carried at much older costs are charged to cost of goods sold.

In a period of rising prices, those old costs are well below current replacement costs. The result is a lower cost of goods sold, higher gross profit and higher taxable income than if the company had kept its inventory level steady. Because this profit comes from an accounting effect rather than from better operations, analysts treat it as a factor reducing the quality of earnings, and public companies disclose material liquidations.

Picture a warehouse where new stock is always stacked on top, and sales always come from the top of the pile. The boxes at the bottom were bought years ago at much lower prices. As long as new boxes keep arriving, the old ones are never touched.

If the business stops restocking and sells deep into the pile, it starts selling those old, cheap boxes. On paper, it looks as though it is making unusually large profits, because it is matching today's selling prices with yesterday's costs. Those profits are real for tax purposes, but they will not repeat once the old stock is gone.

A distributor uses a periodic LIFO system. At the start of the year its inventory has two layers: a base layer of 1,000 units at $10 and a later layer of 500 units at $14. During the year it buys 3,000 units at $20 and sells 3,800 units.

• The 3,000 current-year units at $20 are charged first, $60,000.
• The remaining 800 units come from the old layers: all 500 units at $14, $7,000, and 300 units of the base layer at $10, $3,000.

Cost of goods sold is $70,000. Had the company bought 3,800 units at $20 and kept its inventory level, cost of goods sold would have been $76,000. The liquidation therefore increases pre-tax profit by $6,000. At a 21 percent federal rate this adds $1,260 of income tax expense, and the company's ending inventory is 700 units carried at $7,000.

• Falling demand or a deliberate reduction in stock, for example under a just-in-time program.
• Supply disruptions that prevent a business from replacing goods it has sold.
• Product changes, when old items are discontinued and replaced by new ones in a different LIFO pool.
• Year-end timing, when purchases are delayed until after the reporting date.

Because purchases near year-end can avoid or cause a liquidation, LIFO gives management some ability to influence reported income, which is a common criticism of the method.

Many companies use dollar-value LIFO, which groups goods into broad pools measured in dollars with a price index, so that replacing one product with another does not liquidate a layer. Retailers may use the dollar-value LIFO retail method for the same reason. US tax law also contains limited relief for certain involuntary liquidations caused by qualified supply interruptions, allowing replacement in later years.

Companies registered with the SEC are expected to disclose the effect of a material LIFO liquidation on income, usually in the notes to the financial statements or in management's discussion. Analysts remove the effect when forecasting, since it will not recur, and also look at the LIFO reserve, the difference between LIFO inventory and its FIFO or current cost. A shrinking LIFO reserve alongside falling inventory quantities is a sign that liquidation profits are being reported. Because of the LIFO conformity rule, companies using LIFO for tax must also use it in their financial statements, so the higher income from a liquidation shows up in both. In a time of inflation, the tax bill on a large liquidation can be significant, which is one reason LIFO users try to manage inventory levels around year-end.