It is possible if a company’s accounting system uses FIFO (first-in, first-out), but the company wants its financial and income tax reporting to use a LIFO (last-in, first-out) cost flow assumption due to persistent inflation of its costs. So, the LIFO reserve is a contra inventory account that will reflect the difference between the FIFO cost and LIFO cost of its inventory. With consistently increasing costs, the balance in the LIFO reserve account will have a credit balance resulting in less costs reported in inventory. Recall that under LIFO the latest (higher) costs are also expensed to the cost of goods sold, while the older (lower) costs remain in inventory. The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFO since the time that LIFO was adopted and  the change in the balance during the current year represents the current year’s inflation in costs. Moreover, the change in the balance in the LIFO reserve will also increase the current year’s cost of goods sold.

As the result, that in turn reduces the company’s profits and taxable income. The change in the balance of the LIFO reserve during the current year multiplied by the income tax rate reveals the difference in the income tax for the year and the balance in the LIFO reserve times the income tax rate reveals the difference in income tax since LIFO was adopted.

The disclosure of the LIFO reserve also allows you to better compare the profits and ratios of a company using LIFO with the profits and ratios of a company using FIFO. Since the accounting profession has discouraged the use of the word “reserve” in financial reporting, the inventory notes in annual reports have descriptions, like Revaluation to LIFO, Excess of FIFO over LIFO cost, and LIFO allowance instead of LIFO reserve. Since FIFO and LIFO pertain to the flow of products’ costs and the rate of change in the costs of products. In other words, if the costs of a company’s products are steady, it will not matter whether a company uses FIFO or LIFO. So, the reason is that the first or older costs will be similar to the latest or recent costs.

In contrast, if the costs of its products are increasing significantly, there will be significant difference in profits and inventory values between FIFO and LIFO. In the U.S., the accountants often cite LIFO as the preferred method when products’ costs are changing. Thus, the reason is the matching of the latest costs of products with the sales revenues of the current period. Moreover, U.S. tax rules also allow for either FIFO or LIFO, but require that the same cost flow assumption be used on both the company’s tax return and on the company’s financial statements.

Besides, by using LIFO when the costs of products are increasing, the company will be matching the recent higher costs with the current period sales. Then, this will provide not only the improved matching of costs with revenues and it will also result in lower taxable income. So, during periods of significantly increasing costs, LIFO when compared to FIFO will cause lower inventory costs on the balance sheet and a higher cost of goods sold on the income statement.

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