Definition of LIFO Reserve
The LIFO reserve is a contra inventory account that indicates the difference between the following:
- Inventory cost reported on the balance sheet under the LIFO cost flow assumption
- Inventory cost under the FIFO cost flow assumption
The credit balance in the LIFO reserve reports the difference since the time that LIFO was adopted. The change in the balance during the current year represents the current year's impact on the cost of goods sold.
The disclosure of the LIFO reserve allows readers to better compare the financial statements of a company using LIFO with the financial statements of a company using FIFO. Since the accounting profession has discouraged the use of the word "reserve", the inventory notes in the financial statements have descriptions such as Revaluation to LIFO, Excess of FIFO over LIFO cost, and LIFO allowance instead of LIFO reserve.
Example of LIFO Reserve
A U.S. company's accounting system uses FIFO, but the company wants its financial and income tax reporting to use LIFO due to the persistent increases in the cost of its inventory items. LIFO will result in the most recent higher costs being reported in the cost of goods sold resulting in less gross profit, less net income, less taxable income, and less income taxes than FIFO. LIFO also means that the older lower costs remain in inventory.
With consistently increasing costs (and stable or increasing quantities of inventory items) the balance in the LIFO reserve account will be an ever-increasing credit balance that reduces the company's FIFO inventory cost.