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Last in, first out (LIFO) liquidation occurs when a company that uses the LIFO method of valuing inventory sells off older stock. This can occur because a company's demand is outstripping available inventory and sales numbers are high, or because a company is attempting to move old inventory in order to raise cash or free up space in the warehouse. There are advantages and disadvantages to the LIFO accounting method for inventory, and the same holds true of a LIFO liquidation.
In a company that uses the last in, first out method, it is assumed that the last inventory received is also the first to sell. If a company gets 50 widgets in May and 50 in June, and sells 75 in July, for accounting purposes this is treated as though all of the widgets acquired in June were sold, along with 25 of the widgets purchased in May. It is important to be aware that LIFO refers to accounting, and in actuality, companies do not necessarily dispose of inventory in this way.
In the case of LIFO liquidation, a company sells more than it acquired in a given period, and assumes that it is selling some of the older merchandise. This can result in an inflation in profits, because older inventory is usually purchased at a lower cost price than newer inventory as a result of inflation, but it is sold at the current asking price. Consequently, LIFO liquidation makes it look like a company made more money in a given accounting period.
For tax purposes, this can be a problem. Making more money on sales results in a higher tax liability. Moreover, it can also be used to make a company's financial situation look more solid on paper than it is in real life. Accounting statements may show that a company realized a large profit with a LIFO liquidation, reassuring investors and other concerned parties, but the company can still be in financial trouble.
Learning to read accounting and inventory statements is important for people who want to collect meaningful information from public filings. Understanding the accounting and inventory methods used by a company will provide important clues about what is going on between the lines. In the case of a LIFO liquidation, for example, it could mean that the company is struggling and needs cash, or that it just had a month of unanticipated sales volume, and is actually doing very well.
I worked for a company that pulled a lot of LIFO tricks on its books. We struggled for a long time but our statements did a really good job of hiding this fact.
I knew what they were up to and I even participated in it to a certain extent. I didn't feel great about it but I was conflicted. I really needed that job, and if the company looked like it was struggling it could start to loose contracts and investors. I was perpetuating a lie because I benefited from it.
In the end the company went under anyway. All the accounting tricks in the world could not have saved it towards the end. It was a shame, they were not bad to work for generally, they just had some shady ideas about what it took to stay in business.
I spent a big part of the holiday weekend hanging out with a woman who had worked as an auditor for most of her career. She has worked in both the private and public sectors and has audited companies and organizations both large and small. From hearing her talk about her work so much I can believe that it is important to have someone look over the books that has a keen eye for accounting tricks.
She had some awful stories of people having huge sums embezzled from their company, or companies avoiding huge tax obligations because of sneaky accounting. It makes you feel like no one at all is honest.
But the lesson I took away from it is that you should always have independent verification. In the long run honest and transparency always pay off. If only this idea were more popular in the business community these days.
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