 Hello and welcome to this session in which you would look at LIFO reserve. Well, it's very important to understand what LIFO is before you understand LIFO reserve. What is LIFO? LIFO is a cost flow method just like FIFO and just like average, the average method that we looked at in the prior session. So if you're not sure what a LIFO is, please take a look at the prior session. And what did we conclude from the prior session? We concluded the following specifically for LIFO, that if costs are rising, if we have rising costs, what's going to happen is this? LIFO, it's going to give us the highest cost of goods sold. Why? Because we are matching recent costs with recent sales. So cost of goods sold will be high as a result. Net income will be low as a result. Your taxes are low. Now, if prices are declining and we're talking about LIFO, everything else that you saw here is the opposite. Then if prices are declining, the same concept will apply to FIFO. So make sure you know what happened when prices rising, when prices declining. How does LIFO and FIFO affect your cost of goods sold or ending inventory? Now, we also learned that about the conformity rule, if you're using LIFO for IRS purposes, for tax purposes, you have to use it also for external financial reporting. This brings us to the concept of what is LIFO reserve? LIFO reserve is an intermediate accounting concept as well as a concept that's covered on the CPA exam. Whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course. I'm a useful addition to your CPA review course. I provide supplementary explanation. I provide the theory behind the concept. I help you understand the material better in depth. I give you more examples, which will help you with your CPA review course. My risk is one month of subscription. Your potential gain is adding 10 to 15 points and passing the CPA exam. If not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. This is a list of all my accounting courses, intermediate accounting, managerial accounting, taxation, governmental. You have multiple choice through faults and exercises. Also, my CPA supplementary courses are aligned with your Becker, Roger, Wiley and Gleam. So you can go back and forth between your CPA review course and my material. I also give you access to the AI CPA previously released questions. Almost 1500 CPA questions with detailed solution in addition to my 2000 CPA questions. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation like this recording. Share it with other connect with me on Instagram, Facebook, Twitter and Reddit. So why do companies use LIFO? Well, we just established it's for tax savings, mainly for tax saving, which will give them lower reported profits. So basically they keep deferring their profit until later. Now, for internal purposes, companies don't use LIFO. Company use FIFO or some other method, the average method or some other method. So you might be saying why they use LIFO for external reporting and FIFO for internal reporting. Well, the reason is for one thing, FIFO actually follow the cost flow of goods. So most companies sell their product using FIFO. So for pricing decisions, for pricing decisions, FIFO is better because you need to know how you are pricing your product. For record keeping, it's easier to use FIFO. And specifically for bonus for manager, they use FIFO because if prices are rising, notice if prices are rising and we're using LIFO, we have a lower reported profit. Managers don't look, don't like lower reported profit. They want to show higher reported profit. Therefore, they would want for internally to be using FIFO. So we want to compute our profit using FIFO for bonus purposes. But what we report externally, we need to use LIFO. So what does that mean? It means the company uses LIFO all year long for internal purposes, for pricing decision, for bonus purposes, for record keeping. Then they will need to prepare their financial statements using LIFO. So what do we do? The solution is LIFO reserve. So what we'll do, we'll take the difference between the inventory method for internal reporting for FIFO, for example, and take the difference and see what the difference is and make an adjustment to make it LIFO. The best way to illustrate this is to work an example. Let's assume Adam Company uses FIFO for internal reporting purposes and LIFO for external reporting purposes. On January 1st, 20x5, the allowance to reduce inventory to LIFO balance is 20,000. The long story about this balance, I will show you what that balance is in a moment. At December 31st, we determined that the balance should be 50,000. So this is what we're saying. There is already a balance of 20,000. I will explain what this balance is. But now the balance and the allowance to reduce inventory should be 50,000. And by the way, allowance to reduce inventory is a contra inventory. Well, from the name of it, you should know it's contra inventory. It's an allowance to reduce. It's a contra inventory account. That's why it has a credit balance. What does that mean from a journal entry perspective? It means you need to credit this balance 30,000. In other words, you need to reduce your inventory in additional 30,000. And what happened when you reduce your inventory? When you reduce your inventory, when ending inventory goes down, what goes up cost of goods sold? Because remember what we said, there's a negative relationship. It's very important to understand that ending inventory and cost of goods sold, they have a negative relationship. It means when one goes down, the other goes up. When one goes up, the other goes down. If we're bringing inventory down, it means cost of goods sold should go up. Therefore, we debit cost of goods sold $30,000 to increase our cost. And we book 30,000 of allowance. And this is the journal entry to adjust the inventory from FIFO internal record keeping to LIFO. Now, let me show you what does that 20,000 mean? Well, in the prior year, because we are working in X5, in the prior year X4, I'm just going to give these numbers out, inventory at FIFO was a million dollar inventory for LIFO was 900. No, it should be 980, not 950. It was 980. Therefore, the difference between them was 20,000. And this is where this 20,000 came from from the prior year. Now, in 20X5, we counted our inventory using FIFO was a million 100,000. And for LIFO, it should be 1 million and 50,000. So the difference is 50,000. So to move from 20,000 to 30,000, from 20,000 to 50,000, the difference is 30,000. And this is where the 30,000 adjustment came from. Simply put, it doesn't have to be a million or 1 million 100,000. It could be 100,000 for year X4 and 80,000 for X4. And for X5, it could be, for example, 300,000 for FIFO and for LIFO, it should be 250. It doesn't matter. The difference is 50 for year X5 and 20 for year X4. And the difference to go from 20 to 30. We need a 30,000 dollar. Once again, this is an error here, not 950. The FIFO is 980. I just made an error here. Okay. So hopefully this will explain the concept of the LIFO reserve. In the next session, we will deal with another LIFO issue, which is LIFO liquidation. Again, when we talked about LIFO, I told you we're going to have several issues to deal with when it comes to LIFO. The first thing is LIFO reserve. We covered LIFO reserve. The next thing would look at LIFO liquidation. And after LIFO liquidation, we would look at the dollar value LIFO. Notice all these are issues because we have those, we use LIFO. LIFO last in, first out. What we have is we're having old inventory sitting on the books. At the end of this recording, I'm going to remind you again, whether you are an accounting student or a CPA candidate to take a look at my website, farhatlectures.com. Once again, I don't replace your CPA review course. My material will help you understand your CPA review course better. Look, your risk is one month of subscription. Don't shortchange yourself. You are investing for your CPA. You're investing in your accounting career. This is a lifetime investment. It's worth it. Good luck, study hard. And of course, stay safe.