How does a LIFO reserve work?
John Thompson
Published Feb 16, 2026
The LIFO reserve is an account used to bridge the gap between FIFO and LIFO costs when a company uses the FIFO method to track its inventory but reports under the LIFO method in the preparation of its financial statements.
How does LIFO reserve affect retained earnings?
In equations involving the balance sheet, such as FIFO inventory and FIFO retained earnings, use LIFO reserve. For FIFO, if COGS is lower, then net income and retained earnings must be higher. So, LIFO reserve/change in reserve must be added to LIFO.
Why is the LIFO reserve important?
As indicated above, the LIFO reserve is important for a company because it explains any differences between the LIFO and FIFO accounting methods. In other words, the LIFO reserve is critical because it ultimately offers the most accurate and most complete picture of a company’s inventory, sales, revenue, and profits.
How does LIFO affect the income statement?
When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars. The resulting gross margin is a better indicator of management ‘s ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.
How do you adjust LIFO reserve?
Steps involved in adjusting the financial statements of a company opting for LIFO method to reflect the FIFO inventory cost method are as follows:
- Add the Reserve to Current Asset (Ending Inventory)
- Subtract the Income taxes on the Last in First Out Reserve from Current Assets.
Is LIFO reserve an asset?
A LIFO reserve acts as a contra account, meaning it’s a ledger account used for inventoryInventoryInventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a purposes that shows the differences between the two primary ways inventory is …
What happens when LIFO reserve decreases?
In a deflationary environment, the LIFO reserve will shrink, while the reserve will increase in an inflationary environment. By measuring changes in the size of the LIFO reserve over several periods, you can see the impact of inflation or deflation on a company’s recent inventory purchases.
Can LIFO reserve positive?
LIFO liquidation may also generate positive cash flow and result in higher taxable income and higher tax payments.
Is LIFO reserve a debit or credit?
What is a LIFO Reserve? Assuming prices are increasing, the FIFO valuation of inventory will therefore be greater than the LIFO valuation. In these circumstances, to reduce the FIFO value of inventory to the LIFO value, the LIFO reserve needs to be a credit entry.
