LIFO Reserve

LIFO Reserve - (last in, first out it means that the newest product is going out first), is a difference between FIFO (first in, first out) and LIFO methods used by a company of inventory valuation. It is an overkill of the cost of the company's fund stated at FIFO up the cost stated at LIFO (G. Porter, C. Norton 2007, p. 243). The sum of money "by which income has been reduced by increasing inventory purchases or has been increased by reducing purchases" is called LIFO Reserve (S. Penman 2010, p. 119). The company can decide which cost flow methods want to use. The firm can choose from LIFO, FIFO, VWAP and Specific Identification Method. Choosing the right method has an effect on the future functioning of the business. If a company choose LIFO, it is needed to report the amount of LIFO and FIFO. Simply, the company is required to show LIFO Reserve (P. Kimmel i in. 2009, p. 292). For internal use, a lot of companies use FIFO or standard cost method but for external reports the FIFO method. By increasing revenues and margins by reducing investment in inventories, the company is exposed to LIFO disturbances in the LIFO reserve (S. Penman 2010, p. 119). Modifications in the LIFO reserve can probably purpose the taxpayer rest on to AMT (alternative minimum tax) or extend the cost of AMT (J. Flood 2014, p. 353).

LIFO Reserve formula

LIFO Reserve is for analysis inventory balance and COGS (cost of gods sold). :$LIFO\ Reserve=Inventory\ Balance\ Under\ FIFO\ Method-Inventory\ Balance\ Under\ LIFO\ Method$ After calculation the LIFO reserve we can also calculate the LIFO effect. This is a difference in the balance of the LIFO during a year (P. Delaney, O. Whittington 2009, p. 215-216). :$LIFO\ Effect=LIFO\ Reserve-Beggining\ balance$

Example of LIFO Reserve

Sample content of the task: Expect a company uses a LIFO method for external and FIFO for internal reporting. At the end of the year, the FIFO inventory was 20 000, and the LIFO was 15 000. The LIFO reserve showed at the beginning of a year an amount of 2000. Calculations:

• LIFO Reserve

1. LIFO reserve = FIFO Inventory - LIFO Inventory
2. LIFO reserve = 20 000-15 000
3. LIFO reserve = 5 000

• LIFO Effect

1. LIFO effect = LIFO Reserve - Beginning Balance
2. LIFO effect = 5000-2000
3. LIFO effect = 3000

Advantages of LIFO Reserve

The LIFO Reserve method has a few advantages for the company. These include:

• The ability for a company to reduce its investment in inventory and in turn increase revenues and margins. This allows the company to have more working capital or financial resources that can be invested elsewhere.
• The potential to reduce the company’s tax burden. By reducing the amount of inventory purchase, a company may be able to reduce the amount of federal or state taxes it is required to pay.
• An increased accuracy in accounting. By using the LIFO Reserve method, a company is able to more accurately represent inventory costs and the actual cost of goods sold. This can help the company make better decisions when it comes to pricing and production.
• Increased flexibility in choosing a cost flow method. By using the LIFO Reserve method, a company can choose from FIFO, VWAP, or the Specific Identification Method. This allows the company to choose the method that best suits its needs.

Limitations of LIFO Reserve

One of the major limitations of LIFO Reserve is that * it does not provide accurate information about the true cost of merchandise purchased. This is because the latest costs are used to value the inventory, and these costs may not reflect the cost of the actual item purchased. Additionally, * the use of LIFO Reserve can lead to financial distortions when the cost of goods sold is higher than the cost of goods purchased. This can lead to overstated profits, and can result in higher taxes. Another limitation is that * LIFO Reserve does not take into account the effect of inflation on the cost of goods sold. The prices of goods can increase over time due to inflation, but the LIFO Reserve cost of goods sold will remain unchanged, thus not accurately reflecting the true cost. Additionally, * LIFO Reserve does not consider the actual costs associated with the purchase and sale of goods, such as transportation and storage costs. This can lead to an inaccurate assessment of the true costs of goods purchased, resulting in misstated financial statements. Finally, * LIFO Reserve is not allowed in certain countries, such as the United Kingdom, due to the potential for manipulation of financial records. This can lead to legal issues and the possibility of penalties and fines.

Other approaches related to LIFO Reserve

To complement the understanding of the concept of LIFO Reserve, other approaches related to it are presented below:

• Economic Order Quantity (EOQ) Model - it is an inventory control model that determines the optimum order quantity to be ordered with the objective of minimizing the total inventory costs of the business. It considers the ordering cost, holding cost, setup cost and shortage cost (J. Flood 2014, p. 353).
• Just-in-time (JIT) Inventory System - it is an inventory system that is used to manage the flow of the inventory in order to eliminate the waste due to holding inventory and overproduction by using the lean production system. It is an inventory strategy that is applied to reduce the number of inventories in the organization and increase the efficiency of the production process (P. Kimmel i in. 2009, p. 292).
• Inventory Turnover - it is a measure of the number of times that a company’s inventory is sold and replaced over a certain period of time. It is used to measure how efficiently the company is using its inventory to generate sales (G. Porter, C. Norton 2007, p. 243).

In conclusion, the concept of LIFO Reserve is related to other approaches such as Economic Order Quantity (EOQ) Model, Just-in-time (JIT) Inventory System and Inventory Turnover which help to improve the efficiency of the inventory management and reduce the costs associated with it.

LIFO Reserve — recommended articles

LIFO Liquidation — Inventory value — Cost principle — Operating expense ratio — Net cost — Annual depreciation — Stock turn — Segment margin — Direct costing

References

• Delaney P., Whittington R. (2009), Wiley CPA Exam Review 2010, Financial Accounting and Reporting, John Wiley & Sons
• Flood J. (2014), Wiley GAAP 2015: Interpretation and Application of Generally Accepted Accounting Principles, John Wiley & Sons
• Kimmel P., Jerry J., Kieso D. (2009), Accounting: Tools for Business Decision Making, John Wiley & Sons
• Penman S. (2010), Accounting for Value, Columbia University Press
• Porter G., Norton C. (2007), Financial Accounting: The Impact on Decision Makers, Cengage Learning
• Robinson T., Henry E., Pirie W., Broihahn M. (2015), International Financial Statement Analysis, John Wiley & Sons

Author: Sandra Kaczara