The LIFO Reserve and LIFO Liquidations Explained

Introduction

At the end of 2024, ExxonMobil estimated in its 2024 annual report that the replacement cost of its inventories exceeded their carrying value by about $10 billion. A year earlier the gap had been about $14 billion. The company carries most of its crude oil and refined products on a last-in, first-out (LIFO) basis, so its balance sheet values those barrels at costs dating back decades, far below what it would cost to replace them. The gap, the LIFO reserve, is usually disclosed in the notes rather than on the balance sheet, and it is the key to comparing a LIFO company with one that uses first-in, first-out (FIFO).

The reserve also explains a second, less visible effect. When a LIFO company's inventory shrinks, those decades-old costs flow into cost of goods sold, lowering costs and raising profit for reasons unrelated to operations. ExxonMobil's net income included gains of $176 million in 2024, and $366 million in 2023, from the combined effects of LIFO inventory accumulations and drawdowns. Both effects follow from how LIFO layers work, described in inventory costing: FIFO, LIFO and weighted average.

Under LIFO, each year's purchases are expensed first, and inventory left on the balance sheet is valued at the costs of earlier years. When prices have risen, that inventory is carried well below its current cost. Companies disclose how much higher inventory would be on a FIFO or current-cost basis, and that amount is the reserve.

LIFO reserve

The difference between the value of inventory under FIFO or current cost and its carrying value under LIFO, disclosed in the inventory note. It measures the cumulative effect of LIFO on inventory, and its change in a year equals the difference between LIFO and FIFO cost of goods sold.

For most companies the reserve is a footnote disclosure rather than a balance sheet line; Kroger, which deducts it from FIFO inventory on its balance sheet, is an exception. Despite its name it is not a provision for anything. It grows when prices rise and inventory is maintained, and shrinks when prices fall or when old layers are sold off. Its size relative to inventory shows how far LIFO values have drifted from economic reality: Caterpillar, which values about 65% of its inventories on LIFO, reported that inventories would have been $3.9 billion higher on FIFO at the end of 2024, against reported inventories of $16.8 billion.

Three relationships convert a LIFO company's statements to a FIFO basis, which is what bankers need to compare it with peers reporting on FIFO or under International Financial Reporting Standards (IFRS):

The second relationship follows from the first. Both methods start from the same purchases, so whatever is not in ending inventory under one method is in cost of goods sold. If the reserve grows by $400 in a year, FIFO cost of goods sold is $400 lower than LIFO's, and FIFO pre-tax income $400 higher. The equity adjustment is the cumulative version: FIFO retained earnings are higher by the reserve less the taxes that would have been paid on it.

Caterpillar's 2024 annual report allows the conversion directly:

The $441 million increase in the reserve during 2024 means Caterpillar's cost of goods sold would have been $441 million lower, and its pre-tax income $441 million higher, had all its inventory been on FIFO. Its inventories would have been $3.9 billion higher and its equity higher by that amount less deferred taxes, which matters for asset-based ratios and for how much collateral the inventory could support.

When the Reserve Falls

A falling reserve reverses the adjustment. ExxonMobil's reserve fell by about $4 billion during 2024, a year in which crude oil and refined product prices ended lower than they started, and lower prices narrow the gap between old LIFO costs and current replacement costs. Under the conversion, FIFO cost of goods sold in that year would have been roughly $4 billion higher than ExxonMobil's LIFO figure, because FIFO would have expensed inventory bought at the higher prices of earlier periods. In a period of falling prices, LIFO produces the higher profit, and the reserve shrinks as current costs converge toward the old layers.

A LIFO liquidation occurs when a company sells more inventory than it buys in a year, so that inventory quantities fall below their level at the start of the year. Because LIFO expenses the newest costs first, a company that keeps inventory steady expenses only current-year purchases. Once it starts drawing down inventory, it begins to expense the older layers beneath them, at costs from years or decades earlier.

LIFO liquidation

A reduction in inventory quantities under LIFO that brings older, lower-cost layers into cost of goods sold. In a period of rising prices it lowers cost of goods sold and raises profit and taxable income, an effect that disappears once the drawdown ends.

Suppose a distributor's LIFO base layer is 1,000 units carried at $10, from a year when prices were much lower, and current costs are $30. If it sells 1,000 units more than it buys in the current year, those units are charged to cost of goods sold at $10 instead of $30, cutting cost of goods sold by $20,000 and raising pre-tax income by the same amount. At a 25% tax rate, net income rises by $15,000 and the company owes $5,000 more tax. Nothing about the business has improved; it has simply sold inventory whose cost was recorded long ago.

Liquidations happen for ordinary reasons, such as supply disruptions, deliberate efforts to reduce working capital, falling demand or the closure of a business line, and companies typically disclose their effect when it is material. Kroger, for instance, reported in its fiscal 2022 annual report a LIFO liquidation in 2020, mainly in pharmacy inventory, which reduced its merchandise costs by about $76 million.

The reserve feeds several routine adjustments. In comparable company analysis, bankers restate LIFO users' gross margins and operating income to FIFO when peers use FIFO, using the change in the reserve, or present both bases side by side. In asset-based and return measures, they add the reserve to inventory and to invested capital, as Kroger does in its own return on invested capital calculation, so that a LIFO user's understated inventory does not flatter its returns. In credit work, lenders often value inventory collateral closer to current cost than to LIFO carrying amounts.

In acquisitions, the reserve matters twice. A buyer that steps up a target's assets to fair value in purchase accounting writes the LIFO inventory up to fair value, eliminating the reserve for book purposes and creating a deferred tax liability in a stock deal. If the acquired inventory forms its own LIFO pool, the stepped-up value becomes the new base layer and reaches cost of goods sold only if that layer is later liquidated, whereas a FIFO target's step-up runs through cost of goods sold in the first months after closing. And a buyer that plans to switch the target from LIFO to FIFO for tax faces recapture of the deferred taxes embedded in the reserve, generally spread over several years. The purchase accounting mechanics are covered in purchase price allocation, and the tax effects of write-ups in asset write-ups and deferred taxes in M&A. Across all of these uses, the adjustments line up as follows:

The reserve is a single number in a footnote, but it carries the whole history of a LIFO company's inventory costs. Reading it alongside reported inventory and cost of goods sold, and watching for liquidations when inventory falls, is what turns a LIFO company's statements into figures that can be compared with anyone else's.