The financial statements of any business are greatly affected by the choice of inventory valuation method. The balance sheet, income statement, cash flow statement, and other key financial ratios reflect the choice and impact stakeholders’ decisions.
There are usually three inventory valuation methods. These methods are FIFO(First In, First Out) Inventory, LIFO(Last In, First Out) Inventory, Specific Identification Method, and Weighted Average Cost.
We will not go into the details of each cost approach. But these impact the tax liability, profits, cash flows, and other financial aspects.
The most commonly compared and used methods are LIFO and FIFO methods. The most recent inventory stock is used in the LIFO method first, and the older stock is used later.
The inventory goes out of stock in the same pattern in the FIFO method as it comes in. The stock purchased earlier will be sold out first.
Both methods have different impacts on the financial performance reporting and financial ratios of companies. Therefore, the stockholders must be able to find a uniform space to analyze any company’s health irrespective of cost method.
GAAP requires all businesses to report the LIFO reserve for bookkeeping purposes. LIFO reserve enables the stakeholders to compare the performance of any business without getting confused about inventory methods.
This article will help you understand the concept of LIFO Reserve, its formula, and its implications.
What Is LIFO Reserve?
LIFO Reserve is an accounting term, and it can be defined as,
It is the difference between the reported inventory under the LIFO method and the FIFO method.
We can explain LIFO Reserve is a contra-inventory account. It indicates the difference between LIFO and FIFO inventory method reporting.
As explained by the US GAAP, the LIFO Reserve’s purpose is to disclose financial information for fair representation of financial health.
Most companies use the LIFO method for external reporting due to the tax savings and the non-LIFO method for internal reporting. As a result, a reserve of the difference between LIFO inventory cost and non-LIFO inventory cost.
Important Points About LIFO Reserve
- Using different inventory methods for internal and external reporting, companies want to evade high corporate taxes during inflation time. The LIFO method increases the COGS and low gross income.
- LIFO Reserve is also known as Excess of FIFO over LIFO cost, LIFO allowance, and Revaluation of LIFO. LIFO reserve is a beneficial accounting measure for external stakeholders to assess the profitability and financial health of the company.
LIFO Reserve Formulas
Here are some of the formulas used for the LIFO Reserve calculation.
- If the company uses the FIFO Inventory method for internal reporting and the LIFO method for external reporting, the formula for LIFO reserve is subtracting LIFO inventory from FIFO Inventory
LIFO Reserve Formula = FIFO Inventory – LIFO Inventory
- When the LIFO Reserve has been provided by the company in notes to financial statements. Our FIFO Inventory can be calculated as,
FIFO Inventory = LIFO Inventory – LIFO Reserves
- The cost of goods sold can also be appropriated for the FIFO Inventory method using LIFO COGS and changing in LIFO Reserve. The formula is
COGS (using FIFO) = COGS (using LIFO) – Changes in LIFO Reserve during the Year
By doing little tweaks in the formula for LIFO Reserve, the financial statements of a business using LIFO and another company using FIFO methods can be made comparable.
The term LIFO effect refers to the change in the LIFO reserve during the financial year. The accounting entry for reporting the LIFO effect in books of account will be as follow:
Let’s comprehend the concept of LIFO Reserve with the help of a comprehensive example.
A company operating in the USA uses the FIFO method for accounting and reporting purposes. However, it wants to use the LIFO method for external financial reporting and tax reporting purposes.
The objective of using LIFO for external purposes is the inflationary economic conditions resulting in higher inventory costs.
If the company reports inventory with the LIFO method, the COGS will be higher, and the gross profit will be low. As a result, the taxable income will also be lower. In this way, the company will have to pay low taxes than what they would have to pay by using the FIFO method.
Now, the company has to report the LIFO reserve in the notes to financial statements. The calculation of the LIFO Reserve will be as follow:
From this example, we can see a big difference between the two types of inventory methods. The closing inventory difference is $18. The company will record this difference as a contra-inventory account.
The contra inventory account will reduce the recorded cost of inventory.
Use Of LIFO Reserve In Ratio Analysis
When the external stakeholders are analyzing the company’s financial health and position in the market, they mainly rely on the financial ratio analysis. Financial ratio analysis offers great insight into the performance of the company.
Besides, financial ratios are very crucial when comparing the performance of different companies working in the same industry.
But there are certain ratios like inventory turnover ratios, inventory cycles, etc., that can only be compared if the same inventory method is used.
For instance, the current ratio is the most used and popular ratio to assess a company’s liquidity.
Company ABC used the LIFO method, whereas another competitor company used the FIFO method for inventory valuation. The current ratios of both companies cannot be compared due to this difference in reporting.
By using the LIFO reserve of company A, we can find the FIFO inventory and compare the current ratios of both companies.
FIFO Inventory of Company ABC = LIFO Inventory of Company ABC –LIFO Reserve of Company ABC
We can further calculate the FIFO Cost of goods sold from the FIFO Inventory to find the gross profit and profitability ratios.
FIFO COGS of company ABC = LIFO COGS of company ABC – change in LIFO reserve during the period
Change in LIFO Reserve is the LIFO Effect as discussed above.
All of us are familiar with the famous accounting equation:
Assets = Liability + Shareholder’s Equity
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.
- Adding the LIFO Reserve to the ending inventory on the current asset side will make it FIFO ending inventory
- If the Income taxes on LIFO Reserve are subtracted from the cash balance on the current asset sides
- The LIFO reserve is to be added to the shareholder’s equity. The reserve should be adjusted to reflect tax changes.
- If we subtract the LIFO Effect(Change in LIFO Reserve) from the Cost of Goods sold in the LIFO inventory, it will give COGS under the FIFO Inventory method.
- Income taxes are added on the change in LIFO Reserve to income tax expense in the profit & loss statement.
Benefits Of LIFO Reserve
Throughout this article, we’ve talked about many benefits and reasons why calculating the LIFO Reserve helps companies. Here are some explicit benefits of LIFO Reserve.
- LIFO Reserve is very beneficial for investors and external stakeholders. The financial statements of other companies that are incomparable otherwise can be compared by the calculation of LIFO Reserve.
- By calculating LIFO Reserve, the comparison between the tax impacts of FIFO Inventory and LIFO inventory can be understood. It is the biggest benefit of the LIFO Reserve.
- Companies can also get benefits by calculating LIFO reserves. When the company knows the LIFO Reserve and uses multiple inventory valuation methods, it can adjust its financial statements properly.
- LIFO Reserves calculation enables the company to comply with the accuracy and correctness of the information depicting the true picture of the company’s financial health, sales, taxes, costs, etc.
- The LIFO Effect or change in the LIFO Reserve means changing the cost of goods sold.
The LIFO Reserve is an important accounting calculation mandated by the US GAAP and FASB. The companies must report the LIFO Reserve in their financial statements when they use multiple inventory methods for internal and external reporting.
The main purpose of LIFO Reserve is to bridge the gap between the costs when using LIFO Method and costs when using the FIFO method.
In this article, we’ve tried to comprehend the concept of LIFO Reserve, and how it is useful for investors and businesses. We also discussed the example to elaborate on the concept.