LIFO Reserve

After learning both FIFO and LIFO cost flow assumptions, one can clearly understand that they are two opposing concepts when it comes to valuation of units sold and units held by the period end.

While discussing advantages and disadvantages of LIFO we learnt that entity can enjoy tax benefits because of reduced inventory value and resulting lower profits. However, it posed serious problems for analysts when results are compared with entities using FIFO method that is widely accepted and used. Other reasons that favour the use of FIFO includes:

1. better profit position of entity; entities will be more inclined to use FIFO especially under inflationary economies as it will give higher ending inventory value resulting in higher profits.
2. better reflection of physical flow of inventory i.e. using old units first.
3. Ease of FIFO under both perpetual and periodic inventory systems

Above are only few of the benefits of FIFO over LIFO. Because of these benefits, entities may choose to report profits on the basis of LIFO (in order to take tax benefits) but use FIFO for internal reporting, cost accounting or other decision making purposes.

This is where LIFO Reserve comes under discussion. LIFO reserve is simply a difference of cost of inventory calculated under FIFO and cost of inventory calculated under LIFO. It can be expressed mathematically as follows:

LIFO Reserve = Inventory cost under FIFO – Inventory cost under LIFO

It can be rearranged as follows:

Inventory cost under FIFO = LIFO Reserve + Inventory cost under LIFO

Though it is widely known as LIFO reserve, the use of term “reserve” is much debated as recording of this difference is actually recognizing contra asset against inventory account. Therefore, accountants are using alternative terms such as; LIFO allowance, LIFO effect, LIFO revaluation, Excess of FIFO over LIFO cost etc. However, some accountants use LIFO effect to mean only the change in the reserve during the period therefore, care must be taken to correctly interpret the use of terms.

In simple words LIFO reserve is a tool that helps convert LIFO to FIFO quickly. As we know inventory cost under FIFO is higher than cost under LIFO method that is why in the formula above FIFO cost is sum of LIFO reserve and LIFO cost. In other words, we increase LIFO cost by LIFO reserve to get FIFO cost.

Similarly if we have cost of sales under FIFO method we can determine cost of sales under LIFO method by adding the LIFO reserve in FIFO based cost of sales. And again remember, cost of sales under FIFO will be based on cost lower than the cost on which LIFO cost of sales is calculated.

1 Example – LIFO Reserve / LIFO Allowance

Timberstone Inc uses LIFO method to report inventory in financial statements. However, for managerial purposes FIFO method is used. Timberstone has 259 units by the year end with following values:

If valued using FIFO: 3685
If valued using LIFO: 3222

Difference of these two figures will give LIFO reserve.

LIFO reserve = 3685 – 3222 = 463

2 Example – Inventory analysis and benefit of LIFO reserve

Extracts of current assets and liabilities of two companies are as follows:

[table id=15 /]

Company X uses LIFO method for inventory valuation. In the notes to final accounts entity disclosed the figure of LIFO reserve which is 76,000

Calculate current ratio for both companies with and without LIFO adjustment for company X.

Solution:

Current ratio of Company Y

Total current assets of Y: 247,000
Total current liabilities of Y: 98,800

Current ratio = 247,000 / 98,800 = 2.5

Current ratio of Company X – Without LIFO adjustment

Total Current assets of X: 305,000
Total Current liabilities of X: 150,000

Current ratio = 305,000 / 150,000 = 2.03

Current ratio of Company X – With LIFO adjustment

Total current assets of X:
305,000 + 76,000 = 381,000 [added to make inventory FIFO equivalent]
Total current liabilities of X: 150,000

Current ratio = 381,000 / 150,000 = 2.54

From the above calculations you can clearly see that if company X will yield lower current ratio as compared to company Y as X’s inventory is based on LIFO. It is clear that such comparison basis will cause confusion making users believe that Y is better than X.

As inventory methods are different therefore such comparison is unreliable and unfair. To get better analysis, once X’s inventory is adjusted we can see that its current ratio is even better than Y. After adjustment inventory of both X and Y was according to FIFO thus better comparison basis.

3 Creation of LIFO reserve

In some jurisdictions if entity is using LIFO method then it is required to disclose LIFO reserve. It helps making comparisons easy even if entities are using two different cost assumptions i.e. one using LIFO and other using FIFO.

LIFO reserve is created or raised by simply debiting cost of sales account and crediting a contra asset account that usually goes with the name LIFO Reserve or LIFO Allowance.

Remember these adjustments/entries are not made in entity’s general purpose financial statements rather form part of entity’s internal financial statements or memorandum records. If entity has to report LIFO reserve in general purpose financial statements (available to public), it will go in notes to the accounts.

4 Example – LIFO Reserve accounting entries

Reusing data from Example 1:

Timberstone Inc uses LIFO method to report inventory in financial statements. However, for managerial purposes FIFO method is used. Timberstone has 259 units by the year end with following values:

If valued using FIFO: 3685
If valued using LIFO: 3222

Difference of these two figures will give LIFO reserve.

LIFO reserve = 3685 – 3222 = 463

This difference will be recorded in Timberstone Inc’s internal records as follows:

Continuing this example, suppose next year entity has 500 units of inventory in the end with following figures:

If valued on FIFO basis: 50,000
If valued on LIFO basis: 49,000

Difference is of 1,000. This is the required year end balance of account. However, opening balance is 463. Therefore, additional 537 (1000 – 463) are needed. This change in LIFO reserve is called LIFO effect.

Again, for the second year end 1,000 is the balance of LIFO reserve whereas change during the year, which is 537, is named as LIFO effect. The journal entry for adjustment will be: