What Is LIFO Reserve?
Let me explain what LIFO reserve means in accounting. It's the difference between the first-in, first-out (FIFO) and last-in, first-out (LIFO) costs of inventory that you use for bookkeeping. If your company tracks inventory with FIFO internally but reports using LIFO in financial statements, the LIFO reserve acts as an account to connect those two methods.
Key Takeaways
- Last-in, first-out (LIFO) and first-in, first-out (FIFO) are the two main ways to evaluate inventory.
- With LIFO, you sell the most recently produced assets first, while FIFO means selling the oldest ones first.
- The LIFO reserve measures the difference between FIFO and LIFO inventory costs.
- Most businesses use FIFO for internal purposes but LIFO for external reporting.
- FIFO can show better returns to attract investors, while LIFO helps lower taxes through its calculations.
- You calculate a company's LIFO reserve as FIFO inventory minus LIFO inventory.
- Tracking LIFO reserve lets you accurately compare companies that use different accounting methods.
Understanding LIFO Reserve
You should know that the FIFO method evaluates inventory by assuming the first goods produced are sold or disposed of first. In contrast, LIFO assumes the last goods produced are the ones sold or disposed of first.
This LIFO reserve arises because many businesses, like yours might, use FIFO or a standard cost method internally, but switch to LIFO for external reporting, especially for taxes. This setup is beneficial when prices are rising, as LIFO reporting reduces your tax burden.
LIFO vs. FIFO
Consider this example: When you use LIFO for inventory accounting during rising prices, the reported inventory cost is higher than with FIFO, which increases your cost of goods sold (COGS) and decreases pre-tax earnings. Lower pre-tax earnings mean you pay less in taxes overall.
For internal uses, such as reporting to investors, you can apply FIFO, which shows lower costs and higher margins—something investors find appealing. In rising price periods, this can build a credit balance in the LIFO reserve, leading to lower inventory costs on the balance sheet.
Nearly all analysts examine a publicly traded company's LIFO reserve. You often need to adjust earnings for changes in it, like in adjusted EBITDA or certain adjusted earnings per share (EPS) figures.
Calculating LIFO Reserve
When preparing financials under LIFO, the LIFO reserve is simply the difference in inventory costs between LIFO and FIFO—so, LIFO reserve equals FIFO inventory minus LIFO inventory. You track this to compare companies using different methods accurately.
To keep things precise, calculate the LIFO reserve when you first adopt LIFO. Year-to-year changes in the reserve can roughly indicate that year's inflation, if the inventory type stays the same.
Note that accounting pros discourage calling it a 'reserve' and prefer terms like 'revaluation to LIFO,' 'excess of FIFO over LIFO cost,' or 'LIFO allowance.'
Benefits of LIFO Reserve
One key benefit of the LIFO reserve is that it lets investors and analysts compare companies using different accounting methods on equal footing. The biggest advantage is enabling a clear comparison between LIFO and FIFO, including how they affect taxes.
This helps you adjust financial statements and budgets more effectively for sales, costs, taxes, and profits.
