What is a LIFO Reserve?
The LIFO reserve is an account used to reconcile the difference between the FIFO and LIFO methods of inventory valuation, when a business is using the FIFO method as part of its accounting system but is using the LIFO method to report in its financial statements.
Under the FIFO inventory method (first items in are first out), the inventory at the end of a period contains the items brought into stock last, under the LIFO inventory method (last items in are first out) the inventory at the end of the period contains the items brought into stock first. Assuming prices are increasing, the FIFO valuation of inventory will therefore be greater than the LIFO valuation.
In these circumstances, to reduce the FIFO value of inventory to the LIFO value, the LIFO reserve needs to be a credit entry. This credit balance is then offset against the FIFO inventory valuation resulting in a net balance representing the LIFO valuation. The LIFO reserve account is therefore used as a contra inventory account or more generally a contra asset account.
How to Calculate LIFO Reserve
The balance on the LIFO reserve will represent the difference between the FIFO and LIFO inventory amounts since the business first started using the LIFO inventory method.
The LIFO reserve formula can be stated as follows:
The change in the LIFO reserve for an accounting period reflects the difference between the change in the FIFO inventory and the change in the LIFO inventory as a result of inflation, and is referred to as the LIFO effect.
As the change in inventory is a component of the cost of goods sold, the other side of the double entry posting would be to the cost of goods old account.
The double entry bookkeeping entry to record the LIFO reserve adjustment would be as follows:
|Cost of goods sold||XXX|
|LIFO reserve account||XXX|
The entry effectively increases the cost of goods sold, as under the LIFO method the most recent (and therefore higher cost) items are sold first.
LIFO Reserve Example
Suppose a business has a LIFO inventory reserve at the beginning of the year of 2,000, and at the end of the year the FIFO inventory valuation was 40,000 and the LIFO valuation was 35,000. The LIFO reserve at the end of the year is given by
LIFO reserve = FIFO inventory cost – LIFO inventory cost
LIFO reserve = 40,000 – 35,000 = 5,000
As the opening LIFO inventory reserve was 2,000, the adjustment to the reserve, and the LIFO effect is 5,000 – 2,000 = 3,000, and the double entry bookkeeping entry to record the adjustment would be
|Cost of goods sold||3,000|
|LIFO reserve account||3,000|
The LIFO reserve is sometimes referred to as excess of FIFO over LIFO cost, LIFO allowance, or revaluation to LIFO.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.