What is a LIFO Reserve?
A LIFO reserve acts as a contra account, meaning it’s a ledger account used for inventory purposes that shows the differences between the two primary ways inventory is valued: LIFO (last in, first out) and FIFO (first in, first out). A contra account shows the opposite balance of other ledger accounts. The LIFO reserve account is a contra inventory account that reveals the discrepancy between the LIFO and FIFO calculations of inventory costs.
Breaking Down the LIFO Reserve Account
The LIFO reserve is designed to show how the LIFO and FIFO inventory valuation systems work and the financial differences between the two.
Both the LIFO and FIFO methods fall in line with the Generally Accepted Accounting Principles (GAAP) established by the Financial Accounting Standards Board (FASB) in the US. Most companies utilize both methods when preparing financial information. The goal is to make the presentation of inventory value as attractive as possible. For internal reports, which are viewed by shareholders that benefit from company profit, the FIFO method is typically used because it presents the actual or reasonably expected profit the company stands to generate.
For external financial reports, the LIFO method is typically used. The LIFO method places a higher rate of cost on all the goods that a company sells over the period of a year. With reports that show a higher cost to the company, it also means that less income eligible for taxes is reported alongside it. This is specifically important when sharing things like tax returns with the government because it means the amount of taxes the company accrues is likely to be lower.
In order to create a balance between the two methods and to give a fuller picture of a company’s financial realities, the LIFO reserve account is necessary.
Usefulness of the LIFO Reserve
As indicated above, the LIFO reserve is important for a company because it explains any differences between the LIFO and FIFO accounting methods. In other words, the LIFO reserve is critical because it ultimately offers the most accurate and most complete picture of a company’s inventory, sales, revenue, and profits.
If the LIFO reserve account balance goes up or down, additional costs are then added on to the costs of the goods the company has sold throughout the year. This, in turn, means that less profit is reported. This information is integral for investors because it enables them to see how inflation affects the value of the company’s inventory, or it allows them to determine the taxation benefits of using the LIFO or FIFO accounting methods.
In the simplest way of defining it, the LIFO reserve accounts for the differences between the LIFO and FIFO methods of accounting for inventory value. The significance of the LIFO reserve and its importance to a company, its shareholders, the government, and current or potential investors cannot be underestimated, as it serves as a critical expression of balance for the company’s finances.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below: