LIFO reserve

The reserve is the bridge that makes a LIFO reporter comparable with an IFRS one. FIFO inventory equals LIFO inventory plus the reserve, and because the difference in inventory is the mirror of the difference in cumulative cost of sales, the reserve is also the cumulative pre tax profit difference between the two methods. That identity is a useful check that the adjustment has been applied the right way round.

The balance sheet conversion adds the whole reserve to inventory, then splits the same amount between a deferred tax liability and equity at the relevant tax rate. Adding all of it to equity overstates book value, because the profit that was never reported was also never taxed.

The income statement conversion uses the movement rather than the balance. FIFO cost of sales equals LIFO cost of sales less the increase in the reserve for the year, so a growing reserve means the reported cost of sales was higher and the reported profit lower than a FIFO reporter would have shown.

The movement is also a rough gauge of input cost inflation at that specific company, because the gap between current cost and old layers only widens while replacement costs are running ahead. A reserve that stops growing, or falls, is telling you either that input prices have stopped rising or that the company has been drawing down old layers, which is a LIFO liquidation and needs handling separately.