LIFO Reserve & How to Calculate It
Business owners who use LIFO (Last-in, First-Out) for external reporting on inventory value and FIFO (First-In, First-Out) internally need to keep a contra-inventory account called a LIFO reserve.
The difference between LIFO and FIFO becomes particularly important in environments with rising or fluctuating prices, where the respective calculations may diverge significantly. Understanding how these valuation shifts occur helps small businesses clarify trends in profitability, taxes, and reported inventory value and contributes to informed decision-making.
What Is LIFO Reserve?
LIFO reserve is an accounting adjustment that reveals the difference between the value of a company's inventory under the LIFO method vs the FIFO method. This calculation is useful for internal decision-making regarding inventory items. It also makes it easier for interested outside parties to compare companies that use different inventory methods.
LIFO assigns the most recent (and typically higher) prices to its cost of goods sold (COGS). The result is usually a lower ending inventory value than FIFO when prices are rising.
Reconciling the difference between inventory valuation using FIFO and LIFO is crucial for analysts, investors, and auditors, as it helps them understand the true economic value of inventory. It also facilitates sound analysis of profit trends, including income tax expenses, and ensures consistency, clarity, and compliance in financial reporting.
Inventory accounting has a significant impact on small and medium-sized (SMB) businesses' long-term profitability and success. That's why many partner with experts in small business accounting services.
Why LIFO Reserve Matters for Small Businesses
The LIFO reserve directly impacts how inventory costs flow through financial statements. Significant impacts include the following:
Cost of Goods Sold
One of LIFO's biggest impacts is on COGS, as these are typically higher under LIFO than FIFO. Higher COGS logically leads to lower gross profit and lower taxable income. This tends to be favorable for small businesses as it means a lower tax liability. The LIFO reserve quantifies this benefit by measuring the amount of income being deferred as a result of LIFO's higher expense recognition.
Profitability During Inflation and Deflation
The LIFO reserve also helps SMB owners understand the effect of inflationary periods on their inventory balance. During inflation, the reserve tends to grow. The reverse is true during periods of deflation. This has a flow-on effect on reported income. Decisions about pricing, purchasing, and tax planning are much easier with knowledge of these trends.
Tax Planning and Cash Flow Management
Changes in the LIFO reserve impact your business's taxable income. This makes it a powerful tool for tax planning. Remember, an increased reserve means higher COGS and lower current-year tax payments. This boosts short-term cash flow.
Small businesses that monitor their LIFO reserve over time are better placed to forecast tax liabilities, avoid surprises at tax season, and plan their future cash needs.
Can My Small Business Use the LIFO Inventory Method?
U.S. businesses can use the LIFO inventory method under GAAP. However, the IRS sets out several conditions for businesses that adopt LIFO (page 3 of the PDF). These include keeping adequate records to enable verification of how they calculate inventory value and staying in compliance with their chosen regulations. Your accountant will help you stay on the right side of IRS rules and avoid missteps along the way.
Where to Find the LIFO Reserve in Financial Statements
The LIFO reserve is typically disclosed in the footnotes to a company's financial statements. Most companies don't include it as a separate line on the balance sheet.
Footnotes usually include information about inventory categories, the valuation method used, and a disclosure of the difference between FIFO and LIFO cost of inventory.
How to Calculate LIFO Reserve
The basis formula to calculate LIFO reserve is: LIFO Reserve = FIFO Inventory Value - LIFO Inventory Value
Example
A small manufacturing business in Jacksonville, Florida, uses LIFO for financial reporting. It also tracks its inventory value under FIFO for internal analysis.
At the end of the year, they calculate:
FIFO inventory value: $75,000
LIFO inventory value: $50,000
This makes their LIFO reserve $25,000 ($75,000 - $50,000).
Converting LIFO COGS to FIFO COGS
Use the following formula to convert LIFO COGS into FIFO COGS:
FIFO COGS = LIFO COGS - Change in LIFO Reserve
If the LIFO reserve increases, FIFO COGS will decrease. However, if the LIFO reserve decreases, FIFO COGS will be higher due to LIFO liquidation.
Converting LIFO Net Income to FIFO Net Income
Fluctuations in COGS impact profits. As a result, converting net income from LIFO to FIFO will require an adjustment to allow for the change in the reserve:
If the LIFO reserve increases, FIFO net income will be higher.
If the LIFO reserve decreases, FIFO net income will be lower.
How to Use LIFO Reserve to Adjust Financial Statements
SMBs use the LIFO reserve to adjust financial statements for several reasons. These include:
Making financial statements comparable: The LIFO reserve allows a company using LIFO to translate its numbers into a FIFO basis to make comparison easier.
Complying with reporting requirements: The IRS allows LIFO for tax purposes. However, financial reporting under IFRS (International Financial Reporting Standards) doesn't. A multinational company may want to track a LIFO reserve internally but convert to FIFO for external reporting.
Supporting internal decision-making: Some companies prefer to use FIFO internally (and LIFO externally for tax savings) as it reflects current costs better. This helps plan production, estimate gross margins, evaluate profitability, and set prices.
LIFO Liquidation
Inventory is built up in layers under the LIFO method. Each layer represents purchases made at different costs. A LIFO liquidation occurs when a company sells more inventory than it purchases during any given period. This means they dip into older LIFO layers. These layers were likely to have been recorded at a lower cost. When this happens, companies start expensing older, cheaper layers rather than the most recent and more expensive inventory.
How Does LIFO Liquidation Impact the Reserve?
LIFO liquidation reduces the LIFO reserve account as it narrows the gap between FIFO and LIFO inventory values. One of the most significant upshots of a LIFO liquidation is an artificial inflation of earnings. This is because using lower-cost inventory to calculate COGS causes a drop in expenses. This results in:
Lower COGS
Higher gross profit
Higher net income
Higher taxable income
These consequences may seem overwhelmingly positive. However, this increase in earnings hasn't been caused by implementing more efficient operations or improved pricing. Rather, it stems from an accounting effect caused by selling down inventory.
This boost is ultimately unsustainable if the company doesn't replenish its inventory. When a restock finally comes, future COGS will skyrocket and reverse the temporary profit gains. Business owners must understand these trends to make sound business decisions. This is much easier when you have an expert on your side.
Value Inventory Strategically With LIFO Reserve
The LIFO reserve is essential in bridging the gap between the LIFO and FIFO methods. It enables businesses to understand how inventory valuation impacts financial outcomes. The LIFO reserve also gives invaluable insights into cost behavior, LIFO valuation tax consequences, and the economic reality behind the numbers reported.
The LIFO reserve calculation is a powerful tool to better negotiate pricing, planning, and long-term financial stability. Work with an expert to make the most of this tool, stay compliant, and make the best choices for your business.
