LIFO Reserve Formulas, Examples What is LIFO Liquidation?

In this method, the last purchased goods or recent products are sold or used first. LIFO Reservemeans the difference between the cost of inventory using the last-in, first-out (“LIFO”) method of valuing inventory under GAAP and the cost of inventory using the replacement cost method under GAAP, so long as U.S. Borrower and its Subsidiaries are reporting the value of their inventory under the LIFO method for purposes of GAAP. Whenever the number of units that are sold exceeds the number of units that are purchased or manufactured during a period, the number of units in ending inventory will be lower than the number of units in beginning inventory. In such a circumstance, a company that uses the LIFO method is said to experience a LIFO liquidation wherein some of the older units held in inventory are assumed to have been sold. In this method of inventory, the cost of goods sold is calculated by starting with the latest goods bought.

The LIFO reserve is an account used to bridge the gap between the FIFO and LIFO methods of inventory valuation. The reserve helps to outline the many differences between the two methods and shows how each method would affect the company’s COGS in different situations.

How to Calculate LIFO Reserve?

Assuming rising prices, liquidation of early LIFO layers will result in a charge to cost of goods sold of the older, lower-cost inventory items. Cost of goods sold will decrease, which will result in a higher net income and higher tax liability. 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 what is a lifo reserve 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.

Companies must bridge the gap between both accounts when reporting the value of those goods in the financial statements. Although the choice of LIFO over any other method does not affect the cash flow related to sales, it affects the cost of goods sold. The LIFO liquidation’s effect on the cost of goods sold would affect gross income, which affects income tax, which in turn affects the operating cash flow. During periods of rising inventory unit costs, inventory carrying amounts under the FIFO method will exceed inventory carrying amounts under the LIFO method. The LIFO reserve may also increase over time as a result of the increasing difference between the older costs that are used to value inventory under LIFO and the more current costs that are used to value inventory under FIFO. Additionally, when the number of inventory units manufactured or purchased exceeds the number of units sold, the LIFO reserve may increase due to the addition of new LIFO layers. The primary purpose of using two different valuation methods , is to prepare internal and external financial reports in the most advantageous way possible.

What is the importance of the LIFO Reserve?

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This is specifically important when sharing things like tax returns with the government because it means the amount of taxes the company accrues is likely to be lower. Unfortunately, if the corporate stock is sold, under certain circumstances IRC Section 382 can severely limit the availability of the pre-ownership change net operating loss to offset future income, including LIFO recapture.

LIFO Liquidation

Nevertheless, the purchase price of the stock will definitely be impacted by the LIFO reserves. In essence, the buyer is acquiring the future tax liability from the seller. Other things being equal, this feature in a stock sale generally allows the buyer https://simple-accounting.org/ to buy in for less money than an asset sale because the LIFO tax liability is yet to be realized. Of course, many other considerations play a part in the willingness to buy stock including liabilities and contingencies of the acquired corporation.