The use of the term "reserve" in this concept is discouraged, since it implies the recordation of a contra asset against the inventory line item in the balance sheet. Instead, a business could disclose the “excess of FIFO over LIFO cost”. In a persistently deflationary environment, it is possible for the LIFO reserve to have a negative balance, which is caused by the LIFO inventory valuation being higher than its FIFO valuation. In order to ensure accuracy, a LIFO reserve is calculated at the time the LIFO method was adopted. The year-to-year changes in the balance within the LIFO reserve can also give a rough representation of that particular year's inflation, assuming the type of inventory has not changed.

The Fine company uses FIFO method for internal reporting and LIFO method for external reporting. The inventory on December 31, 2021 is $180,000 under FIFO and $130,000 under LIFO. The LIFO reserve (or allowance to reduce inventory to LIFO) account showed a credit balance of $30,000 on January 1, 2021. When pre-tax earnings are lower, there is a lower amount to pay taxes on, thus, fewer taxes paid overall. The LIFO reserve comes about because most businesses use the FIFO, or standard cost method, for internal use and the LIFO method for external reporting, as is the case with tax preparation. This is advantageous in periods of rising prices because it reduces a company's tax burden when it reports using the LIFO method.

Definition of LIFO Reserve

The LIFO reserve account explains the difference between these two inventory valuation methods since the time LIFO was implemented. Thus, it plays a critical part in the fair presentation of inventory value within the financial statements and clearly discloses the impact of an organizations strategic valuation methodology. If this account balance changes, more costs will be assigned to cost of goods sold for the year causing reported profits to decrease. Investors can use this change to either calculate the tax benefits of using LIFO vs FIFO or see the results of inflation on inventory values. The business organization uses different methods for evaluating inventory but for presentation purposes. Hence, the organization may use FIFO or weighted average accounting and LIFO methods for presentation.

The impact of the LIFO reserve can vary depending on how the transaction is handled. If the dealership buy-sell is an asset sale, the selling dealership entity would likely recapture the entire LIFO reserve as ordinary income in the year of sale. In this instance the actual tax liability on the LIFO reserve has been triggered in full. We can do some adjustments in the accounting equation to reflect the FIFO Inventory costing in the financial statements of the company using LIFO for external uses.

What is a LIFO reserve?

• To the extent the purchase price of the dealership goodwill relates to a multiple of earnings, does LIFO play a role? Yes, as any dealer who has been on LIFO knows, the deductions or income attributable to LIFO which are required to be reflected on the financial statements can dramatically affect the net profit of the dealership. For example, a dealership which makes $100,000 net profit after a $150,000 LIFO deduction should be considered to have earned $250,000 for the purposes of a multiple of earnings calculation.

This would increase the manager's compensation for this period, and have little or no impact on compensation in future periods. In a persistently deflationary environment, the LIFO reserve can have a negative balance, which is caused by the LIFO inventory valuation being higher than its FIFO valuation. LIFO reserve is created or raised by simply debiting cost of sales account and crediting a contra asset account that usually goes with the name LIFO Reserve or LIFO Allowance. The use of this account must be disclosed in the financial statement footnotes, so investors and other external users can appropriately compare metrics.

Understanding LIFO Reserve

The reserve helps to outline the many differences between the two methods and shows how each method would affect the company’s COGS (Cost of Goods Sold) in different situations. The FIFO method favors a stable or deflating Economy, and the LIFO method favors an inflating economy. The LIFO reserve, however, shows a complete and total picture of a company’s finances (profits, sales, costs, revenue, etc.) in all situations. Thus it plays a critical role in presenting the fair value of inventory in the company’s financial statement. The disclosure of the LIFO reserve allows readers to better compare the financial statements of a company using LIFO with the financial statements of a company using FIFO.

• Which tax rate should be used to value the tax effect of LIFO in a stock sale?
• Therefore, the stockholders must be able to find a uniform space to analyze any company’s health irrespective of cost method.
• This is a particularly complex tax issue which should be explored by professional tax advisors on a case by case basis.
• The year-to-year changes in the balance within the LIFO reserve can also give a rough representation of that particular year's inflation, assuming the type of inventory has not changed.
• Because the cost of lipstick keeps rising, your cost of goods sold will be high too.
• The SEC requires that all registered companies that use LIFO report their LIFO reserves for the start and end of the year.

After learning both FIFO and LIFO cost flow assumptions, one can clearly understand that they are two opposing concepts when it comes to valuation of units sold and units held by the period end. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

The use of LIFO reserve in ratios analysis:

Remember, the use of the LIFO inventory method is a tax deferral, not a permanent tax deduction. The contra inventory account will reduce the recorded cost of inventory. It indicates the difference between LIFO and FIFO inventory method reporting. Similarly if we have cost of sales under FIFO method we can determine cost of sales under LIFO method by adding the accrual accounting and prepayments in FIFO based cost of sales. And again remember, cost of sales under FIFO will be based on cost lower than the cost on which LIFO cost of sales is calculated. With consistently increasing costs (and stable or increasing quantities of inventory items) the balance in the LIFO reserve account will be an ever-increasing credit balance that reduces the company's FIFO inventory cost.

• Companies must bridge the gap between both accounts when reporting the value of those goods in the financial statements.
• This is also a good measure of the extent to which a company's reported gross margin is subject to inflationary pressures.
• Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.