The LIFO reserve is the difference between the accounting cost of an inventory that is calculated using the FIFO method and one 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, the LIFO reserve can have a negative balance, which is caused by the LIFO inventory valuation being higher than its FIFO valuation.
The difference between the FIFO and LIFO cost of inventory for accounting purposes. The LIFO reserve is an account used to bridge the gap between FIFO and LIFO costs when a company is using FIFO but would like to report LIFO in its financial statements.
The constant increase in cost can create a credit balance in the LIFO reserve, which results in reduced inventory costs when reported on the balance sheet.