Let's assume that a company's accounting system uses FIFO (first-in, first-out), but the company wants its financial and income tax reporting to use a LIFO (last-in, first-out) cost flow assumption due to persistent inflation of its costs. The LIFO reserve is a contra inventory account that will reflect the difference between the FIFO cost and LIFO cost of its inventory.

With consistently increasing costs, the balance in the LIFO reserve account will have a credit balance—resulting in less costs reported in inventory. Recall that under LIFO the latest (higher) costs are expensed to the cost of goods sold, while the older (lower) costs remain in inventory.

The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFO since the time that LIFO was adopted. The change in the balance during the current year represents the current year's inflation in costs.

The change in the balance in the LIFO reserve will also increase the current year's cost of goods sold. That in turn reduces the company's profits and taxable income. The change in the balance of the LIFO reserve during the current year multiplied by the income tax rate reveals the difference in the income tax for the year. (The balance in the LIFO reserve times the income tax rate reveals the difference in income tax since LIFO was adopted.)

The disclosure of the LIFO reserve allows you to better compare the profits and ratios of a company using LIFO with the profits and ratios of a company using FIFO.

Since the accounting profession has discouraged the use of the word "reserve" in financial reporting, the inventory notes in annual reports have descriptions such as Revaluation to LIFO, Excess of FIFO over LIFO cost, and LIFO allowance instead of LIFO reserve.

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