How do FIFO, LIFO, and weighted average affect financial statements differently?

Question

AcadiFi · Accepted Answer

Great question -- this is one of the most testable FRA topics at Level I. Let's walk through all three methods with the same data set.

**Scenario:** Redwood Hardware Co. starts Q1 with no inventory and makes these purchases and sales:

| Transaction | Units | Cost/Unit |
|---|---|---|
| Jan 5 purchase | 100 | $20 |
| Feb 10 purchase | 150 | $24 |
| Mar 15 purchase | 100 | $28 |
| **Total available** | **350** | |
| Units sold in Q1 | 200 | Selling price $40 |

**Revenue = 200 x $40 = $8,000** for all methods (revenue does not change).

```mermaid
flowchart LR
    subgraph FIFO["FIFO (First In, First Out)"]
        F1["COGS: 100x$20 + 100x$24 = $4,400"]
        F2["Ending Inv: 50x$24 + 100x$28 = $4,000"]
    end
    subgraph LIFO["LIFO (Last In, First Out)"]
        L1["COGS: 100x$28 + 100x$24 = $5,200"]
        L2["Ending Inv: 100x$20 + 50x$24 = $3,200"]
    end
    subgraph WA["Weighted Average"]
        W1["COGS: 200 x $23.43 = $4,686"]
        W2["Ending Inv: 150 x $23.43 = $3,514"]
    end
```

**Weighted average cost** = (100x$20 + 150x$24 + 100x$28) / 350 = $8,200 / 350 = **$23.43**

**Income Statement Impact (Rising Prices):**

| Method | COGS | Gross Profit |
|---|---|---|
| FIFO | $4,400 | $3,600 |
| Weighted Avg | $4,686 | $3,314 |
| LIFO | $5,200 | $2,800 |

**Balance Sheet Impact:**

| Method | Ending Inventory |
|---|---|
| FIFO | $4,000 (closest to current cost) |
| Weighted Avg | $3,514 |
| LIFO | $3,200 (oldest costs, understated) |

**Key Takeaways in Rising Prices:**
- **FIFO** produces the highest net income and highest ending inventory
- **LIFO** produces the lowest net income (highest COGS) and lowest ending inventory, but also the **lowest tax bill**
- **Weighted average** falls between the two

**LIFO Reserve** = FIFO Inventory - LIFO Inventory. Analysts use this to convert LIFO statements to FIFO for comparison.

**Exam Tip:** If prices are falling, these relationships reverse. And remember -- LIFO is prohibited under IFRS, so it only applies to US GAAP reporters.

Explore our CFA Level I inventory practice questions for more drills on this topic.

How do FIFO, LIFO, and weighted average affect financial statements differently?

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Transaction	Units	Cost/Unit
Jan 5 purchase	100	$20
Feb 10 purchase	150	$24
Mar 15 purchase	100	$28
Total available	350
Units sold in Q1	200	Selling price $40

Method	Ending Inventory
FIFO	$4,000 (closest to current cost)
Weighted Avg	$3,514
LIFO	$3,200 (oldest costs, understated)