Definition: LIFO reserve is a contra account used to recognize the difference between the FIFO (first in, first out) and LIFO (last in, first out) methods of inventory valuation.
What Does LIFO Reserve Mean?
What is the definition of LIFO reserve? There are two main inventory valuation methods in accordance with generally accepted accounting principles (GAAP), LIFO and FIFO. It is common for companies to use the FIFO method to manage their inventory internally, while leveraging the LIFO method for financial statement presentation and tax purposes.
The primary purpose of using two different valuation methods (LIFO and FIFO), is to prepare internal and external financial reports in the most advantageous way possible. The FIFO method is applied to internal reports, and often fuels greater profitability. This is more attractive to internal users of the financial statements, such as shareholders, and typically provides a more real or true profit potential of the business.
The LIFO method is applied for external reports, such as tax returns, given that the LIFO method assigns a higher cost to the goods sold during the year. By raising the cost, less taxable income is reported on the income statement; thus, the overall tax expense is also reduced. In order for external users to not be mislead about the true value of inventory, cost of goods sold, and profitability of the company, there needs to be a reconciliation between the two valuation methods.
How is the LIFO reserve used? The LIFO reserve account explains the difference between these two inventory valuation methods since the time LIFO was implemented. Thus, it plays a critical part in the fair presentation of inventory value within the financial statements and clearly discloses the impact of an organizations strategic valuation methodology. If this account balance changes, more costs will be assigned to cost of goods sold for the year causing reported profits to decrease. Investors can use this change to either calculate the tax benefits of using LIFO vs FIFO or see the results of inflation on inventory values.
Let’s look at an example.
Example
In many cases, businesses with significant inventory values rely on advanced ERP systems to maintain the LIFO and FIFO inventory values. This provides the internal accounting departments with the information that is necessary to calculate the LIFO reserve. Simply put, the reserve represents the difference between the two methods of valuation. Here’s a very basic example of the two methods and how the LIFO reserve would be calculated:
Based on the example above, the difference between the two different inventory values would be $5 ($30 – $25). This $5 difference is recorded in a contra inventory account that reduces the recorded cost of the inventory.
The use of this account must be disclosed in the financial statement footnotes, so investors and other external users can appropriately compare metrics.
Summary Definition
Define LIFO Reserves: LIFO reserve means a contra inventory account valued by the difference between the FIFO and LIFO method of inventory valuation.
