What is LIFO Reserve?
LIFO reserve is the difference between what the company’s ending inventory would have been under FIFO accounting and its corresponding value under LIFO accounting. Companies that use LIFO method of Inventory are required to disclose this reserve which can be used to adjust LIFO cost of goods sold and closing Inventory to their FIFO equivalent values to make it comparable.
- Companies can choose to cost their Inventory based on various cost flow methods (namely FIFO, LIFO, Weighted Average Cost and Specific Identification Method).
- This choice of inventory method affect the Income Statement, Balance Sheet and have a direct impact on the various financial ratios which are used by various stakeholders in analyzing the performance of various companies. Additionally, it impacts a company’s Tax liability as well as cash flow.
- Hence, when making a comparison between two companies – Company A that follows LIFO method of inventory and Company B that follows FIFO method of Inventory, the financial performance, and ratios of the two companies become incomparable.
- Therefore to make them comparable, we convert LIFO inventory into FIFO inventory by using this reserve.
US GAAP requires that all companies that use LIFO to also report a LIFO reserve
LIFO Reserve Formulas
- LIFO Reserve formula = FIFO Inventory – LIFO Inventory
When this reserve is provided by the company, we can easily calculate FIFO inventory using the below formula
- FIFO Inventory = LIFO Inventory + LIFO Reserves
Similarly, Cost of goods sold can be adjusted as follows:
- COGS (using FIFO) = COGS (using FIFO) – changes in LIFO Reserve during the Year
Thus by making such necessary adjustments, the financials can be made comparable and the impact of using LIFO method of Inventory reporting, if any, can be neutralized and also any profit attributed due to LIFO Liquidation (discussed above) can also be ascertained to make a better Financial Analysis of the Company.
LIFO reserve is the difference between the cost of inventory computed using the FIFO Method and the LIFO Method.
- By using the LIFO method of Inventory Costing companies are able to increase their cost of goods sold which results in lower Net income and consequently lower taxes in an inflationary period.
- It is also known as Revaluation to LIFO, Excess of FIFO over LIFO cost and LIFO Allowance and helps different stakeholders to better make a comparison of the Net Profits reported by the Companies and various financial metrics.
LIFO Reserve Example
Kappa Corp. uses LIFO inventory accounting. The footnotes to 2007 financial statements contain the following
Calculate Kappa’s 2007 COGS under FIFO
- COGS (FIFO) = COGS (FIFO) – changes in LIFO Reserve
- COGS (FIFO) = 60,000 – (45,000-42,000) = 60,000 – 3,000 = $57,000
Steps involved in adjusting financial statements of a company opting for LIFO method to reflect the FIFO inventory cost method are as follows:
- Add the Reserve to Current Asset (Ending Inventory)
- Subtract the Income taxes on the Last in First Out Reserve from Current Assets (i.e. Cash Balance)
- Add Last in First Out Reserve (Net of Taxes) to Shareholders Equity
- Subtract the change in Last in First Out Reserve from Cost of goods sold
- Add the Income Taxes on the change in the Last in First Out Reserve to Income tax expenses in the Income Statement.
Companies opting for LIFO method of Inventory are required to disclose Last in First Out Reserve in their financial statements footnotes. This method is quite popular in the United States and is allowed under US GAAP (LIFO Method is prohibited under IFRS). A declining reserve is an important indicator which can be used for analyzing the profitability of a company and its sustainability.
- The change in the balance of Reserve account during the year is referred to as the LIFO Effect.
- Usually a declining Reserve is an indication of LIFO Liquidation which happens in cases where a firm is selling more inventory than it purchases during inflationary periods, it results in reducing the cost of goods sold thereby increasing the profits, however such profits are not sustainable and such profits reported by the company needs to be adjusted to avoid the impact of such LIFO Liquidation so as to make them comparable with companies opting for FIFO method.
- Hence changes in LIFO Reserve should be closely analyzed as it allows a meaningful comparison of profits and various financial ratios reported by the company using LIFO Method and company using the FIFO Method.
- Also, it acts as a good measure to understand the impact of the company’s reported Gross Margins to inflationary pressure.
LIFO Liquidation Example
Let’s understand the concept of the LIFO Liquidation with the help of an example:
XYZ International Limited uses the FIFO method for its internal reporting and LIFO method for external reporting. The company’s LIFO Reserve at the beginning of the year showed a credit balance of $25000. At the yearend Inventory as per FIFO stands at $100000 under FIFO method and $70000 under the FIFO method.
- LIFO Reserve Formula = FIFO Inventory-LIFO Inventory = $100000-$70000 = $30000
- Thus LIFO liquidation effect for the year will be $5000 ($30000-$25000).
LIFO Reserves is reported by the companies which use the LIFO method of Inventory reporting as part of their financial statements in their footnotes. This holds relevance as it enables various stakeholders in the business and Analyst community to understand and compare the company’s reported profitability and various financial ratios with companies using the FIFO method of Inventory reporting in a better way.
LIFO Reserve Video
This has been a guide to what is LIFO Reserve. Here we discuss LIFO Reserve Formula, its calculations along with practical examples. Additionally, we look at LIFO Liquidation along with its examples. You may learn more about accounting from the following articles –