The LIFO Reserve
Last-In First-Out (LIFO) is the opposite of First-In First-Out (FIFO). Some systems permit determining the costs of goods at the time acquired or made, but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. Such a reserve (an asset or a contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions.
Seasonal Inventory
Valuing inventory using the LIFO method.
The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity's taxable income has been deferred by using the LIFO method.
LIFO Reserve in Action
Suppose a company uses FIFO for its internal accounting system, but wants to use LIFO for financial and income tax reporting (due to continuous inflation of its costs). In this instance, the LIFO reserve is a contra inventory account that will reflect the difference between the FIFO cost and LIFO cost of its inventory.
During times of increasing costs, the balance in the LIFO reserve account will have a credit balance, meaning that less cost is reported in inventory. Remember, under LIFO the latest (higher) costs are expensed to the cost of goods sold, while the older (lower) costs remain in inventory.
The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFO since the time that LIFO was adopted. The change in the balance during the current year represents the current year's inflation in costs.
Benefits
- The change in the balance in the LIFO reserve will also increase the current year's cost of goods sold. This in turn reduces the company's profits and therefore, taxable income.
- The change in the balance of the LIFO reserve during the current year times the income tax rate results in the difference in the income tax for the year. Changing this formula slightly, one can find the difference in income tax since LIFO was adopted (the balance in the LIFO reserve times the income tax rate).
- The disclosure of the LIFO reserve is better for comparing the profits and ratios of a company using LIFO with the profits and ratios of a company using FIFO.
Additional Information
The accounting profession has discouraged the use of the word reserve in financial reporting, so LIFO reserve may sometimes be called: Revaluation to LIFO, Excess of FIFO over LIFO cost, or LIFO allowance.
LIFO reserve = FIFO inventory - LIFO inventory
FIFO inventory = LIFO inventory + LIFO reserve