LIFO Reserve

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.

US GAAP requires that all companies that use LIFO to also report a LIFO reserve.

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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.read more 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.read more (discussed above) can also be ascertained to make a better Financial Analysis of the Company.

Disclosure

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.

Particulars20062007
COGS5000060000
LIFO Inventory400000460000
LIFO Reserves4200045000

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

Accounting Adjustments

LIFO Reserve

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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.read more opting for LIFO method to reflect the FIFO inventory cost method are as follows:

LIFO Liquidation

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.

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. read more 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).

Conclusion

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 –

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