What is LIFO Reserve?
The LIFO reserve is an accounting term that measures the difference between the cost of first in, first out (FIFO) and last in, first out (LIFO) for accounting purposes. The LIFO reserve is an account used to bridge the gap between FIFO and LIFO costs when a company uses the FIFO method to track its inventory but reports according to the LIFO method in the preparation of its financial statements. In periods of rising prices, constant increases in costs can create a credit balance in the LIFO reserve, which translates into lower inventory costs when reported on the balance sheet.
Almost all analysts examine the LIFO reserve of a publicly traded company. Often, earnings must be adjusted to account for changes in the LIFO reserve, such as adjusted EBITDA and certain types of adjusted earnings per share (EPS).
Understanding the LIFO reserve
The LIFO reserve is due to the fact that most companies use FIFO, or standard cost method, for internal use and the LIFO method for external reports, as is the case for the preparation of tax returns. This is advantageous in times of rising prices because it reduces the tax burden of a company when it declares to use the LIFO method.
For example, when you use the LIFO method for inventory accounting when prices are rising, the cost of declared inventory is higher than the FIFO method, which increases a company’s cost of goods sold (COGS) and lowers pre-tax profits. Then, for internal purposes – as in the case of investor reporting – the same company can use the FIFO method of inventory accounting, which yields lower costs and higher margins.
LIFO reserve calculation
When preparing the company’s financial statements for the LIFO method, the difference in inventory costs between LIFO and FIFO is the LIFO reserve. Consequently, the LIFO reserve of a company = (FIFO inventory) – (LIFO inventory). The LIFO reserve is generally monitored so that companies using different accounting methods can be compared with precision.
In order to ensure accuracy, a LIFO reserve is calculated when the LIFO method is adopted. Year-over-year changes in the LIFO reserve balance can also give an approximate representation of the inflation for that year, assuming that the type of stock has not changed. Account professionals discouraged the use of the word “reserve”, encouraging accountants to use other terms like “revaluation at LIFO”, “excess FIFO over cost of LIFO” and “LIFO allowance”.