LIFO Liquidation

Question: LIFO is also criticized because of the possibility of an event known as a LIFO liquidation. What is a

LIFO liquidation and why does it cause a theoretical problem for accountants?

Answer: As demonstrated above, over time, costs from much earlier years often remain in the inventory T-account

when LIFO is applied. A gasoline station that opens in 1972 and ends each year with a full tank of ten thousand

gallons of gasoline will report its inventory balance at 1972 costs even in the year 2010 when using LIFO.

However, if the quantity of the ending inventory is ever allowed to decrease (accidentally or on purpose), some or

all of those 1972 costs move to cost of goods sold. Revenue earned in 2010 is then matched with costs from 1972.

That is a LIFO liquidation that can artificially inflate reported earnings if those earlier costs are relatively low.

To illustrate, assume that a station starts 2010 with ten thousand gallons of gasoline. LIFO has been applied over

the years so that the inventory is reported at the 1972 cost of $0.42 per gallon. In the current year, gasoline cost

$2.55 per gallon to buy and is then sold to the public for $2.70 per gallon creating a normal gross profit of $0.15

per gallon. That is the amount of income that a station is making at this time.

At the beginning of 2010, the station sells its entire stock of ten thousand gallons of gasoline and then ceases to

carry this product (perhaps the owners want to focus on groceries or automobile parts). Without any replacement

of the inventory, the cost of the gasoline bought in 1972 for $0.42 per gallon is shifted from inventory to cost of

goods sold in 2010. Instead of the normal profit margin of $0.15 per gallon or $1,500 for ten thousand gallons,

the company reports a gross profit of $2.28 per gallon ($2.70 sales price minus $0.42 cost of goods sold). That

amount does not reflect the reality of current market conditions. It allows the company to look overly profitable.

In a LIFO liquidation, costs from an earlier period are matched with revenues of the present year. Revenue

is measured in 2010 dollars but cost of goods sold is stated in 1972 prices. Although the reported figures are

technically correct, the implication that this station can earn a gross profit of $2.28 per gallon is misleading.

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