FIFO vs LIFO — how exactly do they affect COGS, ending inventory, and net income during rising prices?
I'm studying inventory accounting for CFA Level I and I understand the basic idea that FIFO assumes oldest items are sold first and LIFO assumes newest items are sold first. But I keep getting confused about the downstream effects on the income statement and balance sheet, especially when prices are rising. Can someone walk through a concrete example showing how the choice between FIFO and LIFO ripples through the financial statements?
This is a classic CFA Level I FRA question and it shows up on nearly every exam. The key is understanding how the cost flow assumption determines which costs go to COGS (income statement) versus ending inventory (balance sheet).
The Rule of Thumb (Rising Prices):
| Metric | FIFO | LIFO |
|---|---|---|
| COGS | Lower (older, cheaper costs) | Higher (newer, expensive costs) |
| Ending Inventory | Higher (newer, expensive costs remain) | Lower (older, cheaper costs remain) |
| Gross Profit | Higher | Lower |
| Net Income | Higher | Lower |
| Taxes | Higher | Lower |
Worked Example:
Hargrove Supply Co. sells industrial fasteners. In Q1, their purchases were:
| Date | Units | Unit Cost | Total Cost |
|---|---|---|---|
| Jan 5 | 200 | $10 | $2,000 |
| Feb 12 | 300 | $12 | $3,600 |
| Mar 20 | 250 | $15 | $3,750 |
| Total | 750 | $9,350 |
During Q1, Hargrove sold 500 units at $22 each. Revenue = $11,000.
Under FIFO (sell oldest first):
- COGS = (200 x $10) + (300 x $12) = $2,000 + $3,600 = $5,600
- Ending inventory = 250 x $15 = $3,750
- Gross profit = $11,000 - $5,600 = $5,400
Under LIFO (sell newest first):
- COGS = (250 x $15) + (250 x $12) = $3,750 + $3,000 = $6,750
- Ending inventory = (200 x $10) + (50 x $12) = $2,000 + $600 = $2,600
- Gross profit = $11,000 - $6,750 = $4,250
The Impact:
- FIFO shows $1,150 more gross profit ($5,400 vs $4,250)
- FIFO shows $1,150 more in ending inventory ($3,750 vs $2,600)
- At a 25% tax rate, FIFO results in $287.50 more in taxes
Why It Matters for Analysis:
When comparing two companies using different methods, you need to adjust. The LIFO reserve (disclosed in footnotes) lets you convert LIFO to FIFO:
- FIFO inventory = LIFO inventory + LIFO reserve
- FIFO COGS = LIFO COGS - Change in LIFO reserve
Important note: IFRS does not allow LIFO. Only US GAAP permits it. The exam loves testing this distinction.
For a deeper dive into inventory methods and their analytical adjustments, check out our CFA Level I Financial Reporting course on AcadiFi.
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