What is the LIFO Reserve?
The LIFO reserve is an accounting term that measures the difference between the first in, first out (FIFO) and last in, first out (LIFO) cost of inventory for bookkeeping 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 under 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 results in reduced inventory costs when reported on the balance sheet.
Almost all analysts look at a publicly traded company's LIFO reserve. Often earnings need to be adjusted for changes in the LIFO reserve, as in adjusted EBITDA and some types of adjusted earnings per share (EPS).
Understanding the LIFO Reserve
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.
For example, when using the LIFO method for inventory accounting in periods of rising prices, the cost of reported inventory is higher than the FIFO method, which increases a company's cost of goods sold (COGS) and decreases its pre-tax earnings. Then, for internal purposes - such as in the case of investor reporting - the same company can use the FIFO method of inventory accounting, which reports lower costs and higher margins.
Calculating the LIFO Reserve
When preparing company financials for the LIFO method, the difference in costs in inventory between LIFO and FIFO is the LIFO reserve. Therefore, a company's LIFO reserve = (FIFO inventory) - (LIFO inventory). LIFO reserve is usually tracked so that companies using different methods of accounting can be accurately compared.
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. Account professionals have discouraged the use of the word "reserve," encouraging accountants to use other terms like "revaluation to LIFO," "excess of FIFO over LIFO cost" and "LIFO allowance."