LIFO Reserve Explained with Example

Definition

It often happens that companies choose to have the accounting records to be maintained based on methods that are not allowed by the law to be used for reports meant for tax returns or financing. Yet, these methods often prove to be more useful for management decisions.

The FIFO inventory method, for instance, is considered to be more logical and makes it easier to keep track of items and costs. In addition, it is more expensive to maintain records using the LIFO method, so companies choose to maintain internal records using methods other than LIFO. In this case, the company might need to make some adjustments when preparing financial statements for external parties.

As you might recall, with the LIFO method, when materials are released into production or products are sold, the items are written off at the price of the last delivery, then the next item is accounted for at the price of the second to last delivery, etc. The LIFO reserve is the difference between the inventory method used for internal financial reporting purposes and the LIFO inventory accounting method. This is a contra account that has a normal credit balance.

It should be noted that IFRS does not allow companies to work with LIFO. Although it is allowed in the United States, the IRS requires companies to follow the LIFO conformity rule. According to this rule, if a business uses the LIFO accounting method to measure taxable income, it also must use LIFO for external financing reporting.

Example

ProFlowers Shop, for example, had $9,700 on its LIFO reserve account on January 1st, 2020. What does it mean? It means that if the company was using the LIFO method, its inventory balance would have had an additional $9,700. At the end of 2020, the difference between its current inventory accounting method and the LIFO method made up $13,500. To reflect this increase, an adjusting entry should be added to the books.

What entry would need to be made to reflect the change in the balance of the LIFO reserve account? Well, if the beginning balance was $9,700 and ending $13,500, the change in this account is equal to $3,800. We would need to credit the LIFO reserve account to reflect a $3,800 increase in its balance. What other accounts would be affected by this entry? This is the Cost of Goods Sold account because usually, LIFO has a lower Net income and, accordingly, a higher COGS.

Now, what if in 2021 the LIFO reserve account decreases, and the difference is only $12,000? Although this usually does not happen, in this case, we would need to do an opposite journal entry.