Question

Explain the cause of LIFO Liquidation and discuss its impact on the income statement at a time when costs are increasing.

Answer 1

LIFO stands for Last In First Out. It means, inventory purchased later is sold first, that is, Inventory in the last is sold First.

But in LIFO liquidation, entities using LIFO method, start using older stocks. That is, they start removing older stocks.

The purpose of using LIFO method is to sell latest stocks, which are of high price to match the inflation and leading to higher cost of goods sold and less tax burden.

The possible causes of LIFO Liquidation are-

1. Sudden increase in demand, leading the entity to remove older stocks

2. Sudden requirement of cash

3. Older stock got outdated or banned, so selling them at lower or at cost price.

4 Other reasons, such as intention of entity to close down in near future, or due to less space in godowns and warehouse.

Impact of LIFO liquidation on the income statement at a time when costs are increasing -

When entity starts to remove older stocks, their cost is less as compared to the stock purchased later, so it leads to lower cost of goods sold, and higher amount of sales, thereby higher profit and higher tax burden. The entity will not be able to keep at par with inflation.