LIFO Reserve

What is the 'LIFO Reserve'

The LIFO reserve is the difference between the FIFO and LIFO cost of inventory valuation methods used in preparation of a company’s financial statements. The constant increase in cost can create a credit balance in the LIFO reserve, which results in reduced inventory costs when reported on the balance sheet. Accounting professionals have discouraged the use of the word "reserve”, causing accountants to use other terms like revaluation to LIFO, excess of FIFO over LIFO cost and LIFO allowance.

BREAKING DOWN 'LIFO Reserve'

The LIFO reserve increases under inflationary periods and decreases under deflationary periods. The LIFO reserve account has a normal credit balance as the contra asset account will reduce the FIFO inventory figure during inflationary periods. The change in the balance of the LIFO reserve from one period to the next represents the inflation charges from the oldest inventory items to the newest. The LIFO reserve account allows for financial statements to have increased comparability between companies regardless of each company’s inventory valuation method.

LIFO Vs. FIFO Inventory Valuation Methods

The LIFO reserve arises due to the differences between the LIFO and FIFO inventory valuation methods. LIFO requires the last inventory items purchased to be the first to be sold. The FIFO method requires the oldest inventory items to be the specific items sold and the newest inventory items retained as inventory. An issue arises when inventory has been purchased for different prices. For example, a company has the three of the exact same shovel in stock yet paid three different prices to have the items as inventory. Different inventory methodologies will assign different costs if one shovel is sold. This has a direct impact on cost of goods sold and inventory calculations.

Example of LIFO Reserve

A company has 300 widgets in inventory all purchased in the same year, and 100 widgets were purchased on January 1 for $10 each, 100 were purchased on February 1 for $15 each, and 100 widgets were purchased on March 1 for $20 each. Therefore, total inventory equals $4,500. Upon the sale of 50 widgets, the LIFO valuation method will assign $1,000 (50 widgets x $20) to cost of goods sold and the remaining balance of inventory is $3,500 ($4,500 - $1,000). However, under the FIFO method, cost of goods sold would equal $500 ($50 x $10) and ending inventory would be $4,000 ($4,500 - $500). If the company maintains FIFO records, a LIFO reserve inventory line item of $500 ($4,000 inventory valuation under FIFO - $3,500 inventory valuation under LIFO).

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