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Also known as a last-in-first-out reserve, a LIFO reserve is the difference between the first-in-first-out, or FIFO, inventory value and the LIFO inventory value. This type of assessment helps to measure the effect that using the last-in-first-out approach has on the taxes owed on a company’s income. Ideally, utilizing this approach does result in some type of savings for the company. Should this approach not actually result in lowering the taxes owed on the value of the inventory, the figure is recorded as a negative LIFO reserve in the company’s general ledger.
In theory, the idea of the LIFO reserve is to arrange distribution of goods from an inventory in a manner that helps to legally minimize the taxes that are assessed on that inventory for each reporting period. This is accomplished by matching the goods sold during that period with the goods that are most recently purchased and added to the inventory. The goods sold decrease the value of the inventory while the goods purchased add to that value. By strategically arranging the purchases and sales to best advantage, a positive LIFO reserve is created and noted in the accounting records.
While a LIFO accounting method is a common approach in many situations, companies may also utilize the first-in-first-out or FIFO accounting method. As the name implies, there is a quick turnaround between what is disbursed from the inventory and what is purchased to add to the inventory. This method can also be effective in helping to minimize tax obligations, depending on how the tax laws that apply to the location in which the company is operating.
A LIFO reserve is present when the value of the inventory is lower using the LIFO accounting method than it would be using the FIFO accounting method. This approach can be especially effective during periods in which the prices for the recently purchased goods are increasing. By accounting for those recently purchased higher priced items as the cost of goods sold and allowing the goods that cost less to remain in the inventory, the taxes assessed on the inventory are lower than if a FIFO approach was used. The end result is that the higher costs are accounted for on the income statement rather than the company balance sheet, resulting in a lower figure to use for the calculation of the taxes that apply to the period in question. This also means that if the recently purchased items are secured at lower prices and the LIFO approach is used, the LIFO reserve will be negative rather than positive, and likely to result in increasing the amount of taxes due for the period.
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