What is the LIFO Reserve?

For accounting purposes, the term “LIFO reserve” refers to the difference between first-in, first-out (FIFO) and last in, first out  (LIFO) inventory costs. When a business tracks its inventory using the FIFO technique but prepares its financial statements using the LIFO approach, the LIFO reserve accounts for the difference between FIFO and LIFO expenses.

Knowledge about LIFO Reserve

When assessing inventory, the first-produced items and services are the ones that are sold or otherwise disposed of first, according to the FIFO technique. The last-produced products or services should be sold or otherwise disposed of first, according to the LIFO technique of inventory evaluation.

When preparing taxes, the LIFO reserve exists because most companies utilize the FIFO, or standard cost technique, for internal reporting and the LIFO approach for external use. This is helpful when prices rise since it lowers a business’s tax liability when it files utilizing the LIFO technique. An account that is considered a contra inventory is the LIFO reserve. The balance of a contra account is the opposite of the related account.

FIFO versus LIFO

For instance, the cost of reported inventory is higher when utilizing the LIFO technique for inventory accounting during rising prices than when using the FIFO approach. As a result, a company’s cost of goods sold (COGS) increases, lowering its pre-tax profitability. Lower pre-tax earnings mean less to pay in taxes since there is less to pay in taxes.

The same business can then utilize the FIFO inventory accounting method for internal purposes, such as investor reporting, which reflects lower costs and more significant profits, appealing to investors. Constant cost rises during price increases might result in a credit balance in the LIFO reserve, which lowers inventory costs, as reported on the balance sheet.

Almost all analysts examine the LIFO reserve of a publicly listed business. Adjusting earnings for changes in the LIFO reserve is often necessary. Examples include adjusted EBITDA and certain adjusted earnings per share (EPS).

How to Determine LIFO Reserve

When compiling a company’s financials under the LIFO method, the LIFO reserve is the difference in inventory costs between LIFO and FIFO. As a result, the LIFO reserve of a business is equal to (FIFO inventory) minus (LIFO inventory). Generally, LIFO reserves are monitored to enable precise comparisons between businesses with varying accounting systems. A LIFO reserve is determined when the LIFO mechanism is implemented to guarantee correctness. Assuming that the type of inventory has not changed, the annual fluctuations in the balance inside the LIFO reserve can also provide a reasonable estimate of the inflation for that specific year.

Instead of using the phrase “reserve,” accounting professionals advise using terms like “revaluation to LIFO,” “excess of FIFO over LIFO cost,” or “LIFO allowance.”

Qualities of the LIFO Reserve

As previously mentioned, one advantage of the LIFO reserve is that it enables analysts and investors to compare businesses with varying accounting practices equally. The main advantage is that it makes it possible to compare LIFO with FIFO and comprehend any discrepancies, including potential tax implications.

This enables businesses to modify their budgets and financial statements more effectively concerning sales, expenses, taxes, and profits.

CONCLUSION

• The two ways of appraising inventory are last in, first out (LIFO) and first in, first out (FIFO).
• The last produced assets are sold first in LIFO, while the earliest produced assets are sold first in FIFO.
• The LIFO reserve is an accounting measure considering the difference in inventory costs between FIFO and LIFO.
• The LIFO reserve is used because most firms utilize FIFO for internal use but LIFO for external reporting. Due to the precise computations of each approach, FIFO provides favorable returns to investors, while LIFO decreases taxes.
• The LIFO reserve of a corporation is (FIFO inventory) minus (LIFO inventory).
• LIFO reserves are tracked so organizations utilizing different accounting procedures can be compared appropriately.