How do you use the LIFO reserve to compare companies using different inventory methods?

The LIFO reserve is the difference between inventory reported under LIFO and what it would be under FIFO. It is disclosed in the footnotes of US GAAP companies that use LIFO. Here is the adjustment framework:

Core Relationship:

• FIFO Inventory = LIFO Inventory + LIFO Reserve
• FIFO COGS = LIFO COGS − Change in LIFO Reserve

Worked Example:

Brookfield Textiles reports under LIFO. Hargrove Fabrics reports under FIFO. You want to compare them on an equal basis.

Step 1 — Adjust inventory to FIFO basis:

FIFO Inventory = $820,000 + $145,000 = $965,000

This increases total assets and current assets.

Step 2 — Adjust COGS to FIFO basis:

FIFO COGS = $2,300,000 − ($145,000 − $120,000) = $2,300,000 − $25,000 = $2,275,000

Lower COGS means higher gross profit and pre-tax income by $25,000.

Step 3 — Tax effect on equity:

The LIFO reserve increase creates a deferred tax liability.

Retained earnings adjustment = LIFO Reserve x (1 − Tax Rate) = $145,000 x 0.75 = $108,750

Deferred tax liability = $145,000 x 0.25 = $36,250

Impact on Ratios:

• Current ratio rises (higher inventory on the numerator)
• Inventory turnover falls (higher average inventory in denominator, lower COGS in numerator)
• Gross margin rises (lower COGS)
• Debt-to-equity falls (higher equity from retained earnings adjustment)

Key exam tip: In a rising price environment, LIFO produces lower inventory, higher COGS, and lower net income compared to FIFO. The LIFO reserve grows when prices rise and shrinks if prices fall or inventory layers are liquidated (LIFO liquidation).

Practice more inventory analysis in our CFA Level I question bank.