Final answer:
A LIFO liquidation is when older inventory layers are sold under the LIFO method, potentially raising taxable income. Managers avoid it due to potential increased tax liabilities and distortions in financial reporting. They may use strategies or change accounting methods to mitigate the risk.
Step-by-step explanation:
A LIFO liquidation occurs when a company using the Last-In, First-Out (LIFO) inventory costing method sells more inventory than it is replenishing, leading to the liquidation of any inventory quantities acquired in previous periods.
This can result in older, potentially lower-cost inventory being used to value the cost of goods sold, causing a possible increase in the company's taxable income, as the reported cost of goods sold may be lower than it would have been if the inventory was purchased at more recent, higher prices.
Managers try to avoid a LIFO liquidation primarily because it can lead to higher tax liabilities due to an increase in reported income. Furthermore, LIFO liquidation can distort income statements and affect financial ratios negatively, which may mislead investors or reduce the company's ability to comply with debt covenants.
To mitigate these issues, managers may employ inventory management strategies that minimize the risk of liquidating LIFO layers, such as consistent purchasing patterns or switching inventory accounting methods, if applicable and allowed by accounting standards.