The LIFO reserve is the difference between the cost of inventory calculated using the FIFO method and using the LIFO method. Since the reason for valuing an inventory using LIFO is usually to defer the payment of income taxes by increasing the cost of goods sold, the LIFO reserve essentially represents the amount by which an entity's taxable income has been deferred by using the LIFO method. In the typical inflationary environment, the value of a FIFO inventory is higher than the value of a LIFO inventory, so the calculation of the LIFO reserve is:
LIFO Reserve = FIFO Valuation - LIFO Valuation
In a persistently deflationary environment, it is possible for the LIFO reserve to have a negative balance, which is caused by the LIFO inventory valuation being higher than its FIFO valuation.
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. This is also a good measure of the extent to which a company's reported gross margin is subject to inflationary pressures.
The entire LIFO reserve concept disappears if a business uses a weighted-average method to recognize the cost of its inventory, since that approach (as the name implies) uses cost averaging, rather than cost layering, to determine the cost of an inventory.
The use of the term "reserve" in this concept is discouraged, since it implies the recordation of a contra asset against the inventory line item in the balance sheet. Instead, a business could disclose the “excess of FIFO over LIFO cost”.