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 allows companies to better adjust their financial statements and budget in regards to sales, costs, taxes, and profits.
It indicates the difference between LIFO and FIFO inventory method reporting. These methods are FIFO(First In, First Out) Inventory, LIFO(Last In, First Out) Inventory, Specific Identification Method, and Weighted Average Cost. LIFO reserve is the difference between what the company’s ending inventory lifo reserve journal entry would have been under FIFO accounting and its corresponding value under LIFO accounting. Companies that use the LIFO Inventory method are required to disclose this reserve which can be used to adjust the LIFO cost of goods sold and closing Inventory to their FIFO equivalent values to make it comparable.
This is because the conformity rule of IRC § 472(c) requires taxpayers who apply LIFO for tax purposes to also apply it for income measurement in financial reporting, and IFRS does not permit LIFO for book accounting. This disclosure helps people compare inventory costs accurately when different methods are used. A higher LIFO reserve generally indicates rising inventory costs over time. Tracking this reserve provides useful insight balance sheet into cost trends and the potential tax implications if inventory levels decline significantly.
The investors and analysts also study these items to get a clear picture of the business. In these circumstances, to reduce the First In First Out value of inventory to the Last In First Out value, the Last In First Out reserve needs to be a credit entry. This credit balance is then offset against the FIFO inventory valuation resulting in a net balance representing the LIFO valuation. Consequently the Last In First Out reserve account is used as a contra inventory account or more generally a contra asset account.
Companies often face a dilemma with increasing or depleting their LIFO reserve. Heading into “Calculation of LIFO Reserve,” we examine how these adjustments play out numerically on balance sheets and what they mean for business operations. For instance, the current ratio is the most used and popular ratio to assess a company’s liquidity. Besides, financial ratios are very crucial when comparing the performance of different companies working in the same industry. It is the difference between the reported inventory under the LIFO method and the FIFO method. The inventory goes out of stock in the same pattern in the FIFO method as it comes in.
The combined impact is an increased COGS and reduced net income, which can increase tax liability. The change in the LIFO reserve balance each year also impacts cost of goods sold and net income. An increasing reserve lowers COGS and raises net income, while a decreasing reserve does the opposite. We can further calculate the FIFO Cost of goods sold from the FIFO Inventory to find the gross profit and profitability ratios. 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.
Under the LIFO, it is assumed that the inventory that arrives most recently is the one that is used or consumed up first. Therefore, in LIFO reserve equation, the value of cost of goods sold will be the cost of the inventory that is used first. The LIFO Reserve helps analysts and investors compare companies that use different inventory accounting methods. By adding the LIFO reserve to the LIFO-based inventory, one can estimate what the inventory would be under FIFO. In that case, the new principles can be applied prospectively (paragraphs 8–9).
