LIFO Reserve:
(An Issue Related to LIFO Inventory Valuation Method):

Learning objectives of this article:

1. Define and explain the terms "LIFO reserve and LIFO effect".

Definition of LIFO Reserve:

The difference between the inventory method used for internal reporting purposes and LIFO is called "LIFO reserve" or "allowance to reduce inventory to LIFO".

Explanation:

Normally more than inventory methods are used by companies. Many companies use LIFO for tax and external reporting purposes but maintain a FIFO, average cost, or standard cost system for internal reporting purposes. There are several reasons to do so. These reasons are as follows:

1. Companies often base their pricing decisions on a FIFO, average or standard cost assumptions, rather than on a FIFO basis.

2. Record keeping on some other basis is easier because the LIFO assumption usually does not approximate the physical flow on the product.

3. Profit sharing and other bonus arrangements are often on LIFO inventory assumption.

4. The use of a pure LIFO system is troublesome for interim periods, for which estimates must be made of years-end quantities and prices.

The difference between the inventory method used for internal reporting purposes and LIFO is referred to as the allowance to reduce inventory to LIFO or LIFO reserve. The change in the allowance from one period to the next is called the LIFO Effect.

The LIFO effect is the adjustment that must be made to the accounting records in a given year.

Example:

ABC company uses the FIFO method for internal reporting purposes and LIFO for external reporting purposes. At January 1, 2011 the allowance to reduce inventory to LIFO balance was $20,000, and the ending balance should be $50,000. The LIFO effect is therefore $30,000, and the following entry is made at year-end.

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