A firm has just experienced a LIFO liquidation under inflation. Which of the following could be true?
I. The firm's purchases were lower than the number of units sold.
II. The firm experienced a cash drain due to taxes.
III. The firm's income was understated.
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A. B. C. D.D
The LIFO Reserve is defined as the difference between the values of the inventory under FIFO and under LIFO. A decrease in this reserve is referred to as LIFO liquidation. Under the usual case of rising prices, this occurs when units sold exceed units purchased, leading to a "dipping" into the LIFO layers. Since some of the goods sold were purchased at lower prices in previous periods as accounted for by LIFO, COGS gets understated compared to the case where the firm purchases the sold goods in the current period instead of dipping into the LIFO layers. Hence, the firm's income is overstated, leading to higher taxes paid.