Question

Explain what a LIFO reserve is and how firm’s use it to report inventory values in the balance sheet, income statement, and footnotes.

Answer 1

LIFO reserve is an accounting term that measures the difference between the first in, first out (FIFO) and last in, first out (LIFO) cost of inventory for bookkeeping purposes. The LIFO reserve is an account used to bridge the gap between FIFO and LIFO costs when a company uses the FIFO method to track its inventory but reports under the LIFO method in the preparation of its financial statements. In periods of rising prices, constant increases in costs can create a credit balance in the LIFO reserve, which results in reduced inventory costs when reported on the balance sheet.

The change in the balance of LIFO reserve account during the year is referred to as LIFO effect. The value of balance sheet inventory increases as you lower your COGS by liquidating LIFO inventory.LIFO (FIFO) inventory accounting assumes that the newest (oldest) items purchased are the first to be sold. Therefore, under LIFO, a company’s ending inventory consists of the oldest-priced items on hand, and the cost of goods sold consists of the newest-priced items. As prices for inventories rise over time, the value of the older-priced inventory on the books becomes more antiquated, thereby distorting balance sheet inventory accounts. Having higher priced inventory booked to cost of goods sold also lowers a company’s net income compared to what it would be under another inventory accounting method, thus reducing its tax liability.

LIFO liquidations should be disclosed in the footnotes to the financial statements,