LIFO reserve is the difference between the carrying amount of a company's inventories under the first-in first-out (FIFO) method and under the last-in first-out (LIFO) method. LIFO reserve is disclosed by companies that follow LIFO method in accounting for its inventories in order to facilitate the users of financial statements to compare it with companies that might be using FIFO method.
US GAAP allows companies to adopt LIFO cost-flow assumption in inventory accounting but IFRS allows only FIFO and weighted-average methods. Disclosure about LIFO reserve is important in such scenarios for comparability of financial results.
LIFO reserve can be determined as follows:
= Inventory Balance Under FIFO Method – Inventory Balance Under LIFO Method
LIFO reserve is used in financial statement analysis to compare inventory balances and cost of goods sold of companies that use different cost flow assumption. For example, cost of goods sold (COGS) under LIFO method is converted to COGS under LIFO method using the following formula:
COGS Under FIFO Method
= COGS Under LIFO – (Ending LIFO Reserve – Beginning LIFO Reserve)
Susan Meiselas is a Junior Financial Analyst at Taurus Securities. Her supervisor gave her the following data and asked her to calculate inventory turnover ratio for the companies:
|Cost of goods sold||140||120||760||820|
Identify which company uses LIFO method and calculate inventory turnover ratio for the companies for financial year 2014.
The question provides LIFO reserves data for Company B, so it must be using the LIFO method to value its inventories.
FIFO method better approximates the flow of cost of goods sold, so we will calculate the inventory turnover ratios by converting Company B inventories and cost of good sold to equivalent FIFO basis.
Company B inventories at the end of 2013 under FIFO method
= 84 + 180
= 300 million
Company B inventories at the end of 2014 under FIFO method
= 100 + 160
= 260 million
Company B COGS for 2014 under FIFO method
= COGS under LIFO – (ending LIFO reserve – beginning LIFO reserve)
= 760 – (160 – 180)
= 780 million
LIFO reserve has decreased over the period. It means that the company has sold more units that it has purchased. This phenomenon is called LIFO liquidation. It results in sale of old units that were purchased at potentially lower per unit cost.
The inventory turnover ratios are calculated below:
|Inventory turnover ratio for Company A for FY 2014|
|Cost of goods sold||140|
|Average inventory [=(42+48)÷2]||35|
|Inventory turnover ratio||4.00|
|Inventory turnover ratio for Company B for FY 2014|
|Cost of goods sold||780|
|Average inventory [=(260+300)÷2]||280|
|Inventory turnover ratio||2.79|
The LIFO adjustments makes the ratio analysis comparable.