Definition of LIFO Reserve
LIFO Reserve is the difference between the valuation of inventory as per the First in first out (FIFO) method and valuation of Inventory as per Last in first out (LIFO) method of valuation of inventory which is necessary for creating a balance between these two methods as both the methods are valid, and thus it plays a critical role in presenting the fair value of inventory in company’s financial statement.
Explanation
Inventory is valued as per the First in first out (FIFO) method or weighted average method or Last in first out (LIFO) method as per generally accepted accounting policies. The organization generally adopts the FIFO method for internal valuation and the LIFO method for external valuation. Valuation of inventory as per the LIFO Method gives the tax benefit to the organization, but generally, goods are sold on a first-in, first-out basis; hence for internal valuation FIFO method is used. LIFO reserve is the difference between valuation as per FIFO and valuation as per LIFO. If the prices of goods purchased are increasing due to inflation and various other factors, then the LIFO Reserve shows the credit balance. Investors also analyze the LIFO Reserve before investing as it is part of profit or retained earnings.
The formula for LIFO Reserve
LIFO Reserve is the difference between valuation as per the FIFO method and valuation as per the LIFO method. Hence the formula for calculating the LIFO Reserve is as under:
It is also called a contra inventory account as it calculates the difference between valuation as per valuation required by different laws.
How to Calculate LIFO Reserve?
There are the following steps involved in the calculation of LIFO Reserve, which is as under:
- Step 1: Calculate the Valuation of Inventory as per the normal accounting method, i.e., valuation as per the regular method adopted by the organization. It may be FIFO Method, Weighted Average method or LIFO method as all three methods are legally acceptable. If an organization uses the LIFO Method, then there is no LIFO reserve. If FIFO or weighted average method is used, then we will move to step 2
- Step 2: Calculate inventory valuation as per the LIFO Method as tax rules normally suggest the LIFO Method for valuation. Other reason includes the tax benefit given by this. With the valuation as per LIFO basis, the value of inventory tends to be lower than FIFO, or weighted average as prices of raw material are continuous increasing due to various reasons.
- Step 3: Calculate the Difference between valuation as per FIFO basis or valuation as per weighted average basis, i.e., as per the organisation’s regular method. The difference between valuation as per regular method and valuation as per LIFO basis is termed as LIFO Reserve.
Example of LIFO Reserve
US Company uses the FIFO Method in Accounting, but for the purpose of taxation and the financial statement, it wants to adopt the LIFO Method as it reduces the valuation of inventory and increases the cost of goods sold, which ultimately results in less profit and benefit in taxation. The Value of Inventory as per the normal method employed by the organization in accounting, i.e., as per the FIFO method, is $ 38,500, whereas the details of stock are as under:
|
Particulars |
Units | Price / Unit |
Amount($) |
| Opening Stock | 40 units | $ 500 | $ 20,000 |
| Purchases | 500 units | $ 550 | $ 2,75,000 |
Sales 470 Units
Calculate the valuation as per LIFO Method and also calculate LIFO Reserve?
Solution:
Value of Stock as per LIFO Method:
470 units are first sold from purchases of 500 units; hence, the closing stock is 30 units from new purchases and 40 units from opening stock.
- Value of stock as per LIFO Method = (30 units * $ 550) + (40 units * $ 500)
- Value of stock as per LIFO Method = $36,500
Value of Stock as per FIFO Method:
In this case, 70 units of closing stock will be valued according to the rate of new purchases.
- Value of stock as per FIFO Method = 70*$550
- Value of stock as per FIFO Method = $38,500
LIFO Reserve is calculated using the formula given below
LIFO Reserve = Valuation as per FIFO Basis – Valuation as per LIFO Basis
- LIFO Reserve = $38,500 – $36,500
- LIFO Reserve = $2,000
Uses of LIFO Reserve
It is used for the following purposes:
- To offset the operating loss.
- To adjust the valuation effect if debit balance.
- To offset the difference if a negative occurred during the change in the method of valuation.
- Adjust the tax effect if tax rise to higher due to a change in valuation.
Advantages
Following are advantages of LIFO Reserve:
- Used to minimize the tax expenses.
- Used to offset the operating losses that occurred to the organization.
- It helps to decreases the profitability so as to gain.
- Used to adjust the difference in inventory valuation due to other methods of valuation.
- Valuation is as per generally accepted accounting principles.
- Use to keep track of the difference between method used for internal purpose and method used for presentation purpose.
Disadvantages
Following are some of the disadvantages of LIFO Reserve:
- As the track has to be maintained as per internal method and as per external, i.e., LIFO method, it becomes difficult to manage.
- Creates complexity in the accounts.
- It May not be beneficial to the organization as it decreases the interest of investors due to decreases profitability.
- The load on the accounting staff is increased.
- The process involved in calculation is lengthy and time-consuming.
- It is difficult to calculate the value as per the LIFO method as lots of effort and concentration are required. There are also chances of errors due to manual intervention as the value as per LIFO cannot be calculated by the system properly.
Conclusion
The business organization uses different methods for the valuation of inventory but for presentation purpose. It wants to adopt the method that gives the tax benefit. This LIFO method proves to be beneficial in giving the tax benefit. Hence, the organization may use FIFO or weighted average accounting and LIFO methods for the presentation purpose. It is nothing but the difference between valuation as per the organisation’s regular methods and valuation as per the LIFO method. Generally, the LIFO reserve has the credit balance as the price of goods increasing continuously due to inflation and various other reasons, and due to valuation as per LIFO the last purchased, i.e., the high-priced stock is sold and hence the valuation of inventory reduced which led to lower profits and taxation. It is used to set off the operating losses, the difference due to valuation of inventory, etc., but the process involved in the calculation of LIFO Reserve is very lengthy and time-consuming.
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