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Companies can use multiple inventory valuation methods to estimate the value of their goods. This process is crucial to account for those goods. However, accounting standards only allow specific valuation methods when reporting inventory in the financial statements. On the other hand, companies may use another inventory valuation method internally.
This requirement can force companies to calculate the difference in the inventory value under those methods. One such difference is the LIFO reserve.
What does LIFO Reserve mean?
LIFO reserve represents the difference between the inventory value under the FIFO and LIFO valuation methods. The former evaluates goods with preference to the latest inventory values. On the other hand, LIFO uses the oldest inventory values for inventory valuation. If prices differ during periods, it can cause that valuation to differ between both methods.
LIFO reserve allows companies to estimate the gap between the FIFO and LIFO inventory valuation methods. It is critical when companies use different approaches to evaluating inventory internally and externally. In accounting, LIFO reserve refers to the contra account that includes the balance for that difference. It can help explain the variance between the cost of goods sold and inventory value under both approaches.
How does LIFO Reserve work?
The concept of LIFO reserve is straightforward. It represents the difference between the inventory value estimated under the LIFO and FIFO inventory valuation methods. Practically, though, it involves a more detailed process. As stated above, companies use the LIFO reserve when the external and internal inventory valuation methods differ.
For example, a company uses the FIFO method to evaluate its inventory internally. This process entails using the value of the goods bought first for the most recent sales. On the other hand, it reports inventory value based on the latest acquisitions. However, when the company presents inventory in its financial statements, it uses the LIFO method for inventory valuation.
The LIFO method uses the opposite approach to FIFO. It uses the value of goods acquired recently for new sales. On the other hand, it evaluates inventory based on stock purchased earlier. Companies must bridge the gap between both accounts when reporting the value of those goods in the financial statements. For that purpose, they use the LIFO reserve account.
How to calculate LIFO Reserve?
Calculating LIFO reserve requires adjusting two areas. These include the cost of goods sold and the value of inventory. When calculating LIFO reserve, companies can use the following formula.
LIFO Reserve = FIFO inventory value – LIFO inventory value
Practically, calculating the LIFO reserve is not as straightforward. The process involves gauging inventory values under both methods. Based on that, companies can calculate the LIFO reserve. Once estimated, companies can use the LIFO reserve in evaluating inventory. On top of that, it can also apply to calculating the cost of goods sold under each method.
What is the importance of the LIFO Reserve?
LIFO reserve is a highly crucial topic for companies and the users of financial statements. It helps quantify the difference between the LIFO and FIFO valuation methods. Since these methods impact various areas, LIFO reserve can be critical to the financial statements overall. If this reserve fluctuates, it can cause changes in many areas.
However, LIFO reserve isn’t critical for companies only. It also applies to investors and other stakeholders. These parties can use LIFO reserve to compare the financial statements of different companies using LIFO and FIFO. Similarly, they can study the effect of those changes on the various areas described above. Therefore, it can also be crucial in investing decisions.
Conclusion
LIFO reserve quantifies the difference between the FIFO and LIFO inventory valuation methods. In accounting, it represents the contra account that includes that difference.LIFO reserve is crucial when companies use these methods simultaneously. On top of that, it also applies to investors who want to compare various companies that use different approaches.
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