What is the 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 inventoryFIFO InventoryUnder the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost., LIFO inventoryLIFO InventoryLIFO (Last In First Out) is one accounting method for inventory valuation on the balance sheet. LIFO accounting means inventory acquired at last would be used up or sold first., Weighted Average Cost, and Specific Identification MethodSpecific Identification MethodThe specific identification method is one of the accounting methods for inventory valuation that keeps track of each and every item of inventory used in the company from the time it enters the business until it leaves the business, as well as assigning a cost to each item individually rather than grouping them together.).
- 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 flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. .
- Hence, when making a comparison between two companies – Company A that follows the LIFO method of Inventory and Company B that follows the 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 soldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. can be adjusted as follows:
- COGS (using FIFO) = COGS (using LIFO) – 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 LiquidationLIFO LiquidationLIFO liquidation is an event of selling old inventory stock by companies that follow the LIFO Inventory Costing Method. During such liquidation, the stocks valued at older costs are matched with the latest revenue after sales. (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 (LIFO) – changes in LIFO Reserve
- COGS (FIFO) = 60,000 – (45,000-42,000) = 60,000 – 3,000 = $57,000
Steps involved in adjusting the financial statements of a companyFinancial Statements Of A CompanyFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. opting for LIFO method to reflect the FIFO inventory cost method are as follows:
- Add the Reserve to Current Asset (Ending Inventory)Ending Inventory)The ending inventory formula computes the total value of finished products remaining in stock at the end of an accounting period for sale. It is evaluated by deducting the cost of goods sold from the total of beginning inventory and purchases.
- Subtract the Income taxes on the Last in First Out Reserve from Current AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. (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 expensesIncome Tax ExpensesIncome tax is levied on the income earned by an entity in a financial year as per the norms prescribed in the income tax laws. It results in the outflow of cash as the liability of income tax is paid out through bank transfers to the income tax department. in the Income Statement.
Companies opting for the LIFO method of Inventory are required to disclose Last in First Out Reserve in the footnotes of their financial statements. 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 that 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 need to be adjusted to avoid the impact of such LIFO Liquidation so as to make them comparable with companies opting for the FIFO method.
- Hence changes in LIFO Reserve should be closely analyzed as it allows a meaningful comparison of profits and various financial ratiosVarious Financial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on. reported by the company using the 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 Margin 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 balanceCredit BalanceCredit Balance is the capital amount that a company owes to its customers & it is reflected on the right side of the General Ledger Account. Usually, Liability accounts, Revenue accounts, Equity Accounts, Contra-Expense & Contra-Asset accounts tend to have the credit balance. of $25000. At the yearend Inventory as per FIFO stands at $100000 under the 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 –