Contrast cost flow methods for inventory and explain the LIFO reserve
The idea
First-in first-out assigns the oldest costs to cost of goods sold, leaving recent costs on the balance sheet. Last-in first-out does the reverse and is permitted under some standards but not others. In a period of rising prices, LIFO produces higher cost of goods sold, lower reported profit and lower tax, with an understated inventory balance. The LIFO reserve, disclosed in the notes, is the difference between the two valuations, and adding it to LIFO inventory converts the balance to a FIFO basis — which is what makes a LIFO reporter comparable with a FIFO one.
Formulas
LIFO reserve
FIFO inventory = LIFO inventory + LIFO reserve
- LIFO inventory
- inventory as reported by a company using LIFO
- LIFO reserve
- the difference, disclosed in the notes
How to compare a US company reporting under LIFO with one reporting under IFRS, where LIFO is not permitted. Adjusting inventory this way also requires adjusting equity, by the reserve after tax.
A practice question
In a period of rising prices, which method produces the higher cost of goods sold?
- First-in first-outWhy not: FIFO charges the oldest and therefore cheapest units, giving the *lower* cost of goods sold when prices are rising.
- Last-in first-out — correct
- Both produce the same figureWhy not: They coincide only when prices are flat. A rising trend is what separates them.
LIFO charges the most recent and therefore highest costs against revenue, which lowers reported gross profit and taxable income.
A harder one
How is a LIFO inventory balance converted to a FIFO basis?
- By adding the LIFO reserve disclosed in the notes — correct
- By subtracting the LIFO reserveWhy not: The wrong direction. When prices have been rising LIFO is the understated basis, so the reserve is added to bring the balance up to current costs.
- By multiplying by the inventory turnover ratioWhy not: Turnover measures how fast stock moves. It has no role in restating the carrying amount.
The reserve is the cumulative difference between the two measurements. Adding it restores the balance to current costs.
The hardest tier
Why does a LIFO reporter show a lower current ratio than an otherwise identical FIFO reporter in a rising-price environment?
- Because LIFO increases current liabilitiesWhy not: The method touches only the inventory measurement. Liabilities are unaffected.
- Because LIFO excludes inventory from current assetsWhy not: Inventory remains a current asset under either method. What differs is the amount at which it is carried.
- Because LIFO leaves older, lower costs in the inventory balance, understating current assets — correct
The understatement is in the numerator. Any ratio built on current assets or total assets is affected, which is why the reserve adjustment must precede comparison.
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