LIFO Reserve Meaning and How to Calculate It

In order to create a balance between the two methods and to give a fuller picture of a company’s financial realities, the LIFO reserve account is necessary. If a company uses a LIFO valuation when it files taxes, it must also use LIFO when it reports financial results to its shareholders, which lowers its net income. Last in, first out (LIFO) is a method used to account for business inventory that records the most recently produced items in a series as the ones that are sold first. That is, the cost of the most recent products purchased or produced is the first to be expensed as cost of goods sold (COGS), while the cost of older products, which is often lower, will be reported as inventory.

In other words, the LIFO reserve is critical because it ultimately offers the most accurate and most complete picture of a company’s inventory, sales, revenue, and profits. As we are already aware, the LIFO reserve calculation will represent the difference between the value of closing inventory calculated using both LIFO and FIFO. However, any change in the reserve value will be due to changes occurring in the closing inventory calculated using the two methods. In the simplest way of defining it, the LIFO reserve accounts for the differences between the LIFO and FIFO methods of accounting for inventory value.

LIFO Reserves are reported by the companies which use the LIFO method of inventory reporting as part of their financial statements in their footnotes. LIFO reserve is an accounting term that measures the difference between the first in, first out (FIFO) and last in, first out (LIFO) cost of inventory for bookkeeping purposes. The LIFO reserve is an account used to bridge the gap between FIFO and LIFO costs when a company uses the FIFO method to track its inventory but reports under the LIFO method in the preparation of its financial statements. ABC company uses the FIFO method for internal reporting purposes and LIFO for external reporting purposes. At January 1, 2011 the allowance to reduce inventory to LIFO balance was $20,000, and the ending balance should be $50,000.

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1. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries.
2. This reserve is mainly used for taxation purpose in US because it allows companies to defer the tax payments as mentioned above.
3. When pre-tax earnings are lower, there is a lower amount to pay taxes on, thus, fewer taxes paid overall.

It allows them to record lower taxable income at times when higher prices are putting stress on their operations. When pre-tax earnings are lower, there is dirty price a lower amount to pay taxes on, thus, fewer taxes paid overall. LIFO reserve accounting is a concept in the books of accounts that explains the difference between the cost of the closing inventory calculated using LIFO method and the cost of closing inventory derived form FIFO(First In First Out) method. The above are two different but widely used procedures for evaluation of closing balance of inventory. The investors and analysts also study these items to get a clear picture of the business.

Companies that use the LIFO Inventory method are required to disclose this reserve which can be used to adjust the LIFO cost of goods sold and closing Inventory to their FIFO equivalent values to make it comparable. In total, the cost of the widgets under the LIFO method is $1,200, or five at $200 and two at $100. Last in, first out (LIFO) is only used in the United States where any of the three inventory-costing methods can be used under generally accepted accounting principles xero odbc driver (GAAP).

Breaking Down the LIFO Reserve Account

The method allows them to take advantage of lower taxable income and higher cash flow when their expenses are rising. US GAAP allows companies to adopt LIFO cost-flow assumption in inventory accounting but IFRS allows only FIFO and weighted-average methods. Disclosure about LIFO reserve is important in such scenarios for comparability of financial results. In these circumstances, to reduce the First In First Out value of inventory to the Last In First Out value, the Last In First Out  reserve needs to be a credit entry.

Consequently it follows that as the change in inventory is a component of the cost of goods sold, the other side of the double entry posting is to the cost of goods sold account. The balance on the LIFO reserve will represent the difference between the FIFO and LIFO inventory amounts since the business first started using the LIFO inventory method. The credit balance in the LIFO reserve reports the difference since the time that LIFO was adopted. The change in the balance during the current year represents the current year’s impact on the cost of goods sold. A declining reserve is an important indicator that can be used for analyzing the profitability of a company and its sustainability. This method is quite popular in the United States and is allowed under US GAAP (LIFO Method is prohibited under IFRS).

The allowance to reduce inventory to LIFO would be deducted from inventory to ensure that the inventory is stated on a LIFO basis at year-end. The question provides LIFO reserves data for Company B, so it must be using the LIFO method to value its inventories. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping.

When the company provides this reserve, we can easily calculate FIFO inventory using the below formula. The following are the different steps of the calculation of LIFO reserve accounting used in finding out the reserve value for the business. Hence, when comparing two companies – Company A, which follows the LIFO method of Inventory, and Company B, which follows the FIFO method of Inventory, the financial performance and ratios of the two companies become incomparable. Accounting professionals have discouraged the use of the word “reserve,” encouraging accountants to use other terms like “revaluation to LIFO,” “excess of FIFO over LIFO cost,” or “LIFO allowance.” Usually the difference between the cost of inventory at LIFO versus the cost of inventory at FIFO.

LIFO Liquidation

By offsetting sales income with their highest purchase prices, they produce less taxable income on paper. In periods of deflation, LIFO creates lower costs and increases net income, which also increases taxable income. This is why LIFO creates higher costs and lowers net income in times of inflation. FIFO method better approximates the flow of cost of goods sold, so we will calculate the inventory turnover ratios by converting Company B inventories and cost of good sold to equivalent FIFO basis.

The FIFO method assumes that the first units added to inventory are the first ones used, while the LIFO method assumes that the last units added to inventory are the first ones used. In effect, there would be no LIFO reserve if a business did not use LIFO for its tax reporting and FIFO for its financial reporting. A U.S. company’s accounting system uses FIFO, but the company wants its financial and income tax reporting to use LIFO due to the persistent increases in the cost of its inventory items. LIFO will result in the most recent higher costs being reported in the cost of goods sold resulting in less gross profit, less net income, less taxable income, and less income taxes than FIFO. If the LIFO reserve account balance goes up or down, additional costs are then added on to the costs of the goods the company has sold throughout the year. This information is integral for investors because it enables them to see how inflation affects the value of the company’s inventory, or it allows them to determine the taxation benefits of using the LIFO or FIFO accounting methods.

LIFO Reserve Meaning and How to Calculate It

The LIFO effect is therefore $30,000, and the following entry is made at year-end. Most companies use the first in, first out (FIFO) method of accounting to record their sales. The last in, first out (LIFO) method is suited to particular businesses in particular times. That is, it is used primarily by businesses that must maintain large and costly inventories, and it is useful only when inflation is rapidly pushing up their costs.

It directly impacts the various financial ratios that various stakeholders use in analyzing the performance of various companies. As stated, one of the benefits of the LIFO reserve is to allow investors and analysts to compare companies that use different accounting methods, equally. The most important benefit is that it allows a comparison between LIFO and FIFO and the ability to understand any differences, including how taxes might be impacted. The LIFO reserve comes about because most businesses use the FIFO, or standard cost method, for internal use and the LIFO method for external reporting, as is the case with tax preparation. This is advantageous in periods of rising prices because it reduces a company’s tax burden when it reports using the LIFO method. Most companies that use LIFO inventory valuations need to maintain large inventories, such as retailers and auto dealerships.

LIFO is banned under the International Financial Reporting Standards that are used by most of the world because it minimizes taxable income. That only occurs when inflation is a factor, but governments still don’t like it. In addition, there is the risk that the earnings of a company that is being liquidated can be artificially inflated by the use of LIFO accounting in previous years. The LIFO reserve is an account used to reconcile the difference between the FIFO and LIFO methods of inventory valuation. This difference arises when a business is using the FIFO method as part of its accounting system but is using the LIFO method to report in its financial statements. With consistently increasing costs (and stable or increasing quantities of inventory items) the balance in the LIFO reserve account will be an ever-increasing credit balance that reduces the company’s FIFO inventory cost.