FIFO vs LIFO (CFA): The LIFO Reserve Adjustment Explained

Inventory accounting looks like a bookkeeping detail and is examined as a comparability problem. Two identical businesses, one on FIFO and one on LIFO, will report different inventory, different profit, different tax and different cash flow. Level 1 tests whether you can undo that difference.

What each method assumes

These are cost flow assumptions, not statements about which physical units were shipped. A firm using LIFO is not obliged to sell its newest stock first; the assumption governs which costs move to the income statement.

• FIFO — first in, first out. The oldest costs go to COGS; the newest costs remain in ending inventory.
• LIFO — last in, first out. The newest costs go to COGS; the oldest costs remain in inventory.
• Weighted average cost — a blended cost applied to both. Results always sit between the other two.

The permissibility point, which is tested directly: IFRS permits FIFO and weighted average cost but prohibits LIFO. US GAAP permits all three. Any comparison of a US firm with an IFRS reporter therefore has to deal with the possibility that one is on LIFO and the other cannot be.

The effects under rising prices

Almost every exam question specifies rising prices, because that is where the methods diverge visibly. Assume rising costs throughout:

• COGS: LIFO higher (newest, most expensive costs expensed)
• Gross profit and net income: LIFO lower
• Ending inventory: LIFO lower, and made up of old costs that may be badly out of date
• Taxes payable: LIFO lower
• Cash flow: LIFO higher — because of the tax saving
• Working capital and current ratio: LIFO lower

That cash flow line is the one candidates find counterintuitive and the one examiners like. LIFO reports worse profit and produces better cash, because the only real economic difference between the two methods is the tax bill. Everything else is presentation.

Reverse every sign if prices are falling. Questions occasionally specify declining costs precisely to check whether you memorised the outcomes or understood the mechanism.

The LIFO reserve

US firms reporting on LIFO must disclose the LIFO reserve: the difference between what inventory would have been under FIFO and what it is under LIFO. That disclosure is what makes conversion possible, and the conversion is the calculation that appears on the exam.

Inventory:

FIFO inventory = LIFO inventory + LIFO reserve

Cost of goods sold:

FIFO COGS = LIFO COGS − change in LIFO reserve

Net income:

FIFO net income = LIFO net income + [change in LIFO reserve × (1 − t)]

Retained earnings:

FIFO retained earnings = LIFO retained earnings + [LIFO reserve × (1 − t)]

Note the pattern. Balance sheet conversions use the level of the reserve; income statement conversions use the change in it. Income and equity adjustments are after tax; inventory and COGS adjustments are not. Mixing these up is the single most common error in this topic.

Worked example

A firm reports LIFO inventory of $340m, LIFO COGS of $1,250m, and net income of $180m. The LIFO reserve rose from $70m to $95m over the year. Tax rate 25%.

FIFO inventory = 340 + 95 = $435m
Change in reserve = 95 − 70 = $25m
FIFO COGS = 1,250 − 25 = $1,225m
FIFO net income = 180 + (25 × 0.75) = $198.75m

The firm looks considerably more profitable and better capitalised on FIFO, without a single thing changing in the business.

Ratio effects, and the trap in them

Converting from LIFO to FIFO raises inventory and raises net income, so most ratios improve. Two exceptions are worth knowing.

Inventory turnover falls on conversion to FIFO, because COGS falls while average inventory rises — both movements push the ratio down. A LIFO firm therefore looks more efficient on turnover than a comparable FIFO firm, purely as an artefact.

Turnover under LIFO is itself distorted. LIFO COGS uses current costs while LIFO inventory carries old costs, so the numerator and denominator are measured in different price levels. The ratio is not meaningful without conversion, which is the deeper reason analysts convert in the first place.

LIFO liquidation

This is the concept that separates candidates who memorised the table from those who understood it.

If a LIFO firm sells more units than it purchases in a period, it dips into old inventory layers carried at old, low costs. Those low costs flow to COGS, producing artificially low COGS and inflated gross profit.

Three consequences the exam tests:

• The profit increase is not sustainable — it comes from drawing down inventory, not from trading better
• It carries a tax cost, since the inflated profit is taxable
• Analysts should exclude it when assessing ongoing profitability

A vignette showing a LIFO firm with declining inventory levels and unexpectedly strong margins is describing LIFO liquidation, whether or not it uses the term.

Inventory valuation after cost is assigned

Separate from the cost flow choice, inventory must be written down when its value falls. The rules differ by framework, and the difference is examinable:

• IFRS: lower of cost and net realisable value. Write-ups are permitted, but only to reverse a previous write-down.
• US GAAP: for LIFO and retail inventory methods, lower of cost or market with a defined ceiling and floor; for other methods, lower of cost and net realisable value. Reversals are not permitted.

The takeaway line for an exam: IFRS allows reversal of a write-down, US GAAP does not. That asymmetry is the point.

Exam checklist

• IFRS prohibits LIFO; US GAAP permits it
• Rising prices, LIFO: higher COGS, lower income, lower tax, higher cash flow, lower inventory
• Balance sheet conversions use the reserve level; income statement conversions use the change
• Income and retained earnings adjustments are after tax
• Declining inventory plus strong margins at a LIFO firm signals liquidation
• Under IFRS a write-down may be reversed; under US GAAP it may not