What is the LIFO Reserve?

  • 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.read more, 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.read more, 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.read more).This choice of inventory method affects the Income Statement, Balance Sheet. It directly impacts the various financial ratios that various stakeholders use in analyzing the performance of various companies. Additionally, it impacts a company’s Tax liability and 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. read more. Hence, when comparing two companies – Company A, which follows the LIFO method of Inventory, and Company B, which follows the FIFO method of Inventory, the financial performance and ratios of the two companies become incomparable.Therefore, we convert LIFO Inventory into FIFO inventory by using this reserve to make them 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 the company provides this reserve, 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 the 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.

  • Using the LIFO method of Inventory, Costing companies can 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 make a better 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 ReserveCOGS (FIFO) = 60,000 – (45,000-42,000) = 60,000 – 3,000 = $57,000

Accounting Adjustments

The 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 the 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.read moreSubtract 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.read more (i.e., Cash Balance)Add Last in First Out Reserve (Net of Taxes) to Shareholders EquitySubtract the change in Last in First Out Reserve from Cost of goods soldAdd the Income Taxes on the Last in First Out Reserve change 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.read more in the Income Statement.

LIFO Liquidation

A declining reserve is an important indicator that can be used for analyzing the profitability of a company and its sustainability. This method is quite popular in the United States and is allowed under US GAAP (LIFO Method is prohibited under IFRS). Companies opting for the LIFO method of Inventory are required to disclose Last in First Out Reserve in the footnotes of their financial statements.

  • The change in the Reserve account balance during the Year is referred to as the LIFO Effect.Usually, a declining reserve indicates LIFO Liquidation, which happens in cases where a firm is selling more Inventory than it purchases during inflationary periods; it reduces the cost of goods sold, thereby increasing the profits. However, such profits are not sustainable. Such profits reported by the company need to be adjusted to avoid the impact of such LIFO Liquidation to make them comparable with companies opting for the FIFO method.Hence, changes in LIFO Reserve should be closely analyzed. It allows a meaningful comparison of profits andFinancial 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.read more 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.read more 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 on 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 internal reporting and the LIFO method for external reporting. At the yearend Inventory as per FIFO stands at $100000 under the FIFO method and $70000 under the FIFO method. At the beginning of the Year, the company’s LIFO Reserve showed a credit balance of $25000.

  • LIFO Reserve Formula = FIFO Inventory-LIFO Inventory = $100000-$70000 = $30000Thus LIFO liquidation effect for the Year will be $5000 ($30000-$25000).

Conclusion

LIFO Reserves are reported by the companies which use the LIFO method of inventory reporting as part of their financial statements in their footnotes. It 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 LIFO Reserve is. Here we discuss the LIFO Reserve Formula and its calculations and practical examples. Additionally, we look at LIFO Liquidation along with its examples. You may learn more about accounting from the following articles –

  • Days in Inventory FormulaLIFO Liquidation DefinitionFIFO vs. LIFO Inventory Turnover Ratio