LIFO Reserve

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LIFO Reserve
See also

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, s. 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, s. 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, s. 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, s. 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, s. 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, s. 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

References

Author: Sandra Kaczara