Key Takeaways
- Dive into crucial inventory evaluation methods: Last in, first out (LIFO) and first in, first out (FIFO).
- Understand how LIFO prioritizes the sale of last produced assets, unlike FIFO which prioritizes first produced assets.
- Comprehend the concept of LIFO Reserve, which bridges the gap between the FIFO and LIFO cost of inventory.
- Discover why businesses often use FIFO internally but switch to LIFO for external reporting and tax purposes.
- Note that FIFO is beneficial for investor appeal, whereas LIFO optimizes tax obligations due to its strategic calculations.
- Recognize that a company’s LIFO reserve is calculated as: (FIFO inventory) - (LIFO inventory).
- Learn why tracking LIFO reserve is essential for comparing companies using different accounting methods.
Understanding LIFO Reserve
The FIFO method of evaluating inventory hinges on the principle where the oldest produced goods or services are sold first. Conversely, the LIFO method is based on the newest produced goods being disposed of or sold first.
The inception of the LIFO reserve is rooted in the dual approach businesses adopt—using the FIFO method internally and the LIFO method for external reporting, primarily for tax purposes. This practice is particularly advantageous during inflationary periods, as reflecting inventory costs using LIFO can significantly reduce a company’s tax burden.
LIFO reserve manifests as a contra inventory account, holding a balance opposing the primary inventory account to which it is related.
Inspiring Insights: LIFO vs. FIFO
Example: Leveraging LIFO During Price Inflation
Stepping into realistic scenarios, consider a company using the LIFO method amid rising prices. Here, the cost attributed to reported inventory is higher compared to using the FIFO method. Resultantly, this swells the company’s cost of goods sold (COGS) and shrinks its pre-tax earnings. Reducing pre-tax earnings invariably translates to lower tax liabilities.
Internally, for purposes like investor reporting, this same company may adopt the FIFO method, highlighting lower costs and thus higher profit margins. This strategy is especially appealing to investors seeking better margins.
Persistently rising costs lead to an accumulating credit balance in the LIFO reserve, contributing to reduced inventory costs when outlined on the company’s balance sheet.
Virtually all analysts focus on a publicly-traded company’s LIFO reserve. To ensure accurate reflections, adjustments are often necessary for altered calculations in the LIFO reserve, manifested in metrics such as Adjusted EBITDA and certain adjusted earnings per share (EPS) formulations.
Calculating LIFO Reserve: A Practical Approach
During the preparation of financial outputs via the LIFO method, the LIFO reserve signifies the cost difference between inventories calculated using LIFO and FIFO. Thus, the formula:
LIFO reserve = (FIFO inventory) - (LIFO inventory)
This reserve is meticulously tracked to enable fair comparisons among companies using disparate accounting methodologies.
Accuracy in the LIFO reserve computation necessitates its calculation from the point of LIFO method adoption. Annual changes in this balance offer insights into inflationary pressures, provided the nature of the inventory remains unchanged.
Accounting experts advise against the generic term ‘reserve,’ promoting alternative terminologies like ‘revaluation to LIFO,’ ’excess of FIFO over LIFO cost,’ or ‘LIFO allowance.’
Benefits of Maintaining a LIFO Reserve
The outstanding advantage of the LIFO reserve is facilitating investor and analyst comparisons accurately across companies leveraging different accounting approaches. Most importantly, it underscores the differences in tax implications between the LIFO and FIFO methods.
In essence, understanding the variations, inclusive of taxation effects, enables companies to fine-tune their financial statements, budgeting strategies, and broader business planning effectively.
Related Terms: FIFO, LIFO, Inventory Accounting, Contra Account, Cost of Goods Sold (COGS).
