LIFO liquidation often distorts net income, but usually leads to substantial tax savings

LIFO liquidation often distorts net income, but usually leads to substantial tax savings. True False

The correct answer and explanation is:

True

LIFO (Last In, First Out) liquidation occurs when a company using the LIFO inventory method sells more inventory than it purchases, causing older, lower-cost inventory to be recognized in the cost of goods sold (COGS). In such a scenario, companies may experience a substantial tax advantage but also distort their net income.

Here’s how this works:

1. LIFO and Inventory Valuation: Under LIFO, the most recently purchased items are the first ones sold. This typically means that the cost of goods sold reflects the most recent (and usually higher) purchase prices, leaving older, lower-cost inventory on the books.
2. Impact of LIFO Liquidation: During LIFO liquidation, when a company sells more inventory than it purchases, the company must begin selling the older, cheaper inventory that remains in stock. The result is that the cost of goods sold (COGS) decreases because the older inventory is being used, and the revenue generated by the sales is recognized against these lower costs.
3. Effect on Net Income: Since the cost of goods sold drops, the company reports higher gross profit and, subsequently, higher net income. However, this higher net income does not reflect the company’s current cost of acquiring inventory, which can be misleading.
4. Tax Savings: The substantial tax savings arise because the company is reporting lower COGS in a LIFO liquidation scenario. Lower COGS means higher taxable income, but when older inventory is used in the sale, the company is still operating under a tax-advantageous scenario where the older inventory values are lower, reducing its tax liability.

In conclusion, LIFO liquidation can cause distorted financial results by inflating net income, but it also results in a tax benefit because the older, cheaper inventory reduces the immediate tax burden. However, this benefit can be temporary, as it may reverse in future periods when the company replenishes its inventory at higher prices.