Clevency
- FIFO and LIFO at a glance
- Worked numerical example (rising prices)
- Falling prices: the pattern reverses
- The 4-scenario impact table
- The LIFO Reserve and conversion formula
- LIFO liquidation: the hidden profit boost
- How this appears on the CFA exam
- Practice question with worked solution
- Frequently asked questions
FIFO and LIFO at a glance
Inventory cost-flow methods decide which cost sits in COGS (expensed) versus which sits in Ending Inventory (on the balance sheet). The physical flow of goods may be independent of the accounting assumption — a grocer sells its oldest milk first regardless of what COGS method it reports.
- FIFO: oldest costs go to COGS; newest costs stay on the balance sheet.
- LIFO: newest costs go to COGS; oldest costs stay on the balance sheet.
- Weighted average: blended cost across all units; the compromise option.
Worked numerical example (rising prices)
Suppose a retailer buys 100 units at USD 10 in January, then 100 units at USD 12 in June. By December it has sold 80 units at USD 20 each.
Under FIFO — oldest costs expensed first:
- COGS = 80 units × USD 10 = USD 800
- Ending inventory = 20 units × USD 10 + 100 units × USD 12 = USD 200 + USD 1,200 = USD 1,400
- Revenue = 80 × 20 = USD 1,600
- Gross profit = 1,600 − 800 = USD 800
Under LIFO — newest costs expensed first:
- COGS = 80 units × USD 12 = USD 960
- Ending inventory = 100 units × USD 10 + 20 units × USD 12 = USD 1,000 + USD 240 = USD 1,240
- Gross profit = 1,600 − 960 = USD 640
With prices rising, LIFO reports USD 160 higher COGS and USD 160 lower gross profit — and therefore lower tax. The USD 160 difference is the LIFO Reserve (ending inventory FIFO − ending inventory LIFO = 1,400 − 1,240 = USD 160).
Falling prices: the pattern reverses
Repeat the example with prices falling: 100 units at USD 12 in January, 100 units at USD 10 in June. 80 units sold.
Under FIFO — expense the USD 12 purchases first: COGS = USD 960.
Under LIFO — expense the newer USD 10 purchases first: COGS = USD 800.
The ranking flips entirely. Under falling prices, LIFO produces lower COGS, higher profit, higher tax, and higher ending inventory — the opposite of the rising-price case.
The 4-scenario impact table
| Metric | Rising prices — FIFO | Rising prices — LIFO | Falling prices — FIFO | Falling prices — LIFO |
|---|---|---|---|---|
| COGS | Lower | Higher | Higher | Lower |
| Gross profit | Higher | Lower | Lower | Higher |
| Tax expense | Higher | Lower | Lower | Higher |
| Net income | Higher | Lower | Lower | Higher |
| Ending inventory | Higher (newer costs) | Lower (older costs) | Lower (newer, cheaper) | Higher (older, dearer) |
| Working capital | Higher | Lower | Lower | Higher |
| Current ratio | Higher | Lower | Lower | Higher |
| Inventory turnover | Lower | Higher | Higher | Lower |
| Cash from operations | Lower (higher tax) | Higher (lower tax) | Higher (lower tax) | Lower (higher tax) |
The LIFO Reserve and conversion formula
US GAAP firms using LIFO are required to disclose the LIFO Reserve in a footnote — the difference between what their inventory would be under FIFO and what it is under LIFO.
LIFO Reserve = FIFO Inventory − LIFO Inventory
To restate a LIFO firm's balance sheet to FIFO (for comparability with an IFRS peer):
- Inventory (FIFO) = Inventory (LIFO) + LIFO Reserve
- Retained Earnings (FIFO) = Retained Earnings (LIFO) + LIFO Reserve × (1 − t)
- Deferred Tax Liability (FIFO) = DTL (LIFO) + LIFO Reserve × t
- Current year COGS (FIFO) = COGS (LIFO) − ΔLIFO Reserve
- Current year Net Income (FIFO) = NI (LIFO) + ΔLIFO Reserve × (1 − t)
The after-tax adjustment is the detail that catches candidates. The reserve change hits earnings, so the pre-tax adjustment × (1 − t) is what adds to retained earnings or net income; the rest sits in deferred tax.
LIFO liquidation: the hidden profit boost
If a LIFO firm sells more inventory than it buys in a period, it dips into older, cheaper layers of inventory. Those old costs are expensed as COGS, inflating gross profit abnormally. This is called LIFO liquidation. It is non-sustainable — it stops as soon as the old layers are exhausted — and CFA Institute wants candidates to identify it and strip it out of forward-looking analysis.
How this appears on the CFA exam
FIFO vs LIFO is a Level 1 FSA topic and reappears briefly at Level 2 under inventory and ratio analysis. The exam patterns:
- Given a sequence of purchases and sales, compute COGS and ending inventory under both methods.
- Given a LIFO firm's financials and the LIFO Reserve, restate to FIFO for inventory, COGS, net income, and current ratio.
- Explain the directional effect of FIFO vs LIFO on four ratios (current ratio, inventory turnover, gross margin, debt/equity).
- Identify LIFO liquidation from a declining LIFO Reserve and an inventory drawdown.
Practice question with worked solution
Question: Priya Nair, CFA, is analysing Firm A (uses LIFO) and Firm B (uses FIFO). Firm A reports: Ending inventory USD 500, COGS USD 2,000, LIFO Reserve USD 150 (up from USD 100 last year), tax rate 25%, Net income USD 300. Compute Firm A's FIFO-equivalent ending inventory, COGS, and net income.
Solution:
FIFO Inventory = 500 + 150 = USD 650
Change in LIFO Reserve = 150 − 100 = USD 50
FIFO COGS = 2,000 − 50 = USD 1,950
FIFO Net Income = 300 + 50 × (1 − 0.25) = 300 + 37.5 = USD 337.5
Frequently asked questions
Why would a company choose LIFO?
Primarily for the tax benefit. In rising-price environments, LIFO produces lower taxable income and therefore lower cash tax. The firm sacrifices reported net income for cash savings.
Why is LIFO not allowed under IFRS?
IFRS views LIFO as producing a balance-sheet inventory that no longer reflects current economic value — older costs may be decades old. IFRS prioritises current-value representation over tax-management flexibility.
What happens during LIFO liquidation?
COGS temporarily drops as the firm expenses old, cheap layers of inventory, producing an artificial profit boost that is not sustainable. Analysts strip this out of normalised earnings estimates.
How does LIFO affect cash taxes?
In rising-price environments, LIFO reduces current cash tax by expensing newer, more expensive inventory. The deferred tax saving is real cash — this is the main reason US firms adopt LIFO.
What is the LIFO conformity rule?
In the US, a firm that uses LIFO for tax must also use LIFO for financial reporting. This is why LIFO disclosures appear in US GAAP financials but not in IFRS statements.
Does changing from LIFO to FIFO count as a change in accounting policy?
Yes, treated as a retrospective change in accounting principle under US GAAP. Prior-period financials are restated. CFA questions sometimes test the mechanics of such a conversion.