Analysis of Inventories

Financial Statement Analysis, LOS weight share 0.8 percent of the 365 Level I learning outcomes.

Financial Statement AnalysisAnalysis of Inventories

The exam only ever tests rising prices unless it tells you otherwise, and the one time it does not tell you, that silence is the whole question.

Before you watch

Answer these three first. Getting them wrong now is normal, and it helps the lesson stick. Reveal the answers when you're done, then read on.

1. A company reports LIFO inventory of $400,000 and discloses a LIFO reserve of $90,000. An analyst restating to a FIFO basis should report inventory closest to:

Answer: C. FIFO inventory equals LIFO inventory plus the LIFO reserve, since the reserve represents exactly the amount by which LIFO understates inventory relative to FIFO in a rising-price environment.

2. A company operating under IFRS is choosing among inventory cost methods. It is permitted to use:

Answer: A. IAS 2 explicitly prohibits LIFO. IFRS-reporting companies may use only FIFO or weighted-average cost; US GAAP is the regime that additionally permits LIFO.

3. During a period of rising prices, compared to a company using FIFO, an otherwise identical company using LIFO will report:

Answer: B. LIFO assigns the most recent, higher-priced purchases to cost of goods sold, producing higher COGS, lower gross profit and net income, and leaving older, lower-cost layers in ending inventory, which is why US companies facing rising costs often use LIFO to defer taxes.

The lesson

Runtime 14 minutes 8 seconds, measured from the published video.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to describe how inventory is measured at the lower of cost and net realisable value, calculate how rising or falling inventory costs affect COGS, gross profit and taxes under FIFO versus LIFO, convert a LIFO reporter's figures to a FIFO-equivalent basis using the disclosed LIFO reserve, and describe what a LIFO liquidation signals.

Three inventory cost methods answer the same question differently: which cost do you assign to the units that left the shelf. FIFO, first in first out, sends the oldest costs to cost of goods sold and keeps the newest costs on the balance sheet. LIFO, last in first out, does the reverse: the most recent purchase cost goes to COGS, and older costs stay in ending inventory. Weighted average blends every cost together and sits between the other two. None of these describes which units physically left the warehouse. They are cost flow assumptions, and the exam tests which one you apply, not which one is realistic.

Assume prices are rising unless a question says otherwise, because that is the exam's default case. Under rising prices, LIFO sends the newest, most expensive costs to COGS. COGS rises, gross profit falls, and taxable income falls with it, while ending inventory stays low because it carries the old, cheap costs. FIFO does the opposite under the same rising prices: cheap old costs go to COGS, expensive new costs stay on the balance sheet, and both inventory and reported profit come out higher. Neither method is wrong. They simply tell two different stories about the identical set of purchases and sales.

Because a LIFO reporter and a FIFO reporter are not directly comparable, US GAAP requires a LIFO company to disclose its LIFO reserve, the exact gap between what its inventory would be under FIFO and what it actually reports under LIFO. Two conversion formulas move in opposite directions, and mixing them up is the most common error on this module. FIFO inventory equals LIFO inventory plus the full LIFO reserve, added because FIFO always carries the higher figure when prices rise. FIFO cost of goods sold equals LIFO cost of goods sold minus only the change in the reserve during the period, never the reserve's full ending balance. Restating equity for this conversion requires one more step: the after-tax portion of the reserve, the reserve multiplied by one minus the tax rate, is what actually flows to equity, since the remaining tax-rate portion becomes a deferred tax liability instead.

IFRS prohibits LIFO outright, with no exceptions and no grandfathering for a company that used it before adopting IFRS; seeing IFRS named in a question eliminates LIFO from consideration immediately. A LIFO liquidation happens when a company sells more units than it purchases in a period, drawing down older, lower-cost inventory layers. It temporarily boosts gross profit, not hurts it, because those old cheap costs get matched against current revenue. Analysts flag it as an earnings-quality warning rather than a compliment, because the improvement disappears once the old layers run out.

Worked in full

A company reporting under LIFO shows inventory of $520,000 and cost of goods sold of $1,150,000. Its disclosed LIFO reserve is $95,000 at year end, up from $70,000 at the start of the year. What are FIFO-equivalent inventory and FIFO-equivalent COGS? FIFO inventory = LIFO inventory + LIFO reserve = $520,000 + $95,000 = $615,000. The change in the reserve over the year = $95,000 - $70,000 = $25,000. FIFO COGS = LIFO COGS - change in reserve = $1,150,000 - $25,000 = $1,125,000.

The same problem, one step removed

Same company: LIFO inventory $520,000, LIFO COGS $1,150,000, LIFO reserve $95,000 at year end versus $70,000 at the start of the year. Compute FIFO-equivalent inventory using the full reserve, then compute FIFO-equivalent COGS using only the reserve's change.

The trap

The two LIFO-to-FIFO formulas move in opposite directions and by different amounts: inventory gets the full reserve added, but COGS gets only the reserve's change over the period subtracted; using the ending reserve balance for the COGS conversion is the most repeated arithmetic error on this module.

Learning outcomes covered by this module

Verbatim from the 2026 CFA Level I topic outline. Every practice question and key rule below is tagged to one of these where the stem and explanation make the match clear.

  1. describe the measurement of inventory at the lower of cost and net realisable value and its implications for financial statements and ratios
  2. calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods
  3. describe the presentation and disclosures relating to inventories and explain issues that analysts should consider when examining a company's inventory disclosures and other sources of information

Key rules

Written from this module's own lesson and the 2026 CFA Level I topic outline, in teaching order, each tagged to the learning outcome it belongs to where that is clear.

LOS 01

Inventory is carried at the lower of cost and net realisable value under IFRS, or lower of cost or market under US GAAP

IFRS measures inventory at the lower of cost and net realisable value, estimated selling price minus costs to complete and sell, and permits writing a previously written-down value back up (not above original cost) if conditions later improve. US GAAP measures inventory at the lower of cost or market and, once a write-down is taken, does not allow it to be reversed even if the market price later recovers.

LOS 02

In rising prices, LIFO raises COGS and lowers taxes; in falling prices, the direction reverses

LIFO expenses the most recently incurred cost first; when prices are rising, that recent cost is the highest, producing higher COGS, lower gross profit, and lower taxable income than FIFO, and leaving the oldest, cheapest costs in ending inventory. When prices are falling, the same mechanics run in reverse: LIFO produces lower COGS and higher income than FIFO. Weighted-average cost always sits between FIFO and LIFO results in either price environment.

LOS 02

Converting a LIFO reporter to a FIFO basis uses the disclosed LIFO reserve, not a guess

FIFO inventory equals LIFO inventory plus the disclosed LIFO reserve; FIFO cost of goods sold equals LIFO cost of goods sold minus the change in the LIFO reserve during the period, not the reserve's ending balance. The after-tax portion of the reserve, LIFO reserve multiplied by one minus the tax rate, is the adjustment that flows to equity when restating a balance sheet; the remaining, tax-rate portion becomes a deferred tax liability.

LOS 03

LIFO liquidation temporarily inflates gross profit, and is a flag, not a compliment

When a company sells more units than it purchases in a period, it draws down older, lower-cost LIFO layers, matching stale cheap costs against current revenue and producing an unsustainable, one-time boost to gross margin. This is disclosed because it is a real earnings-quality concern: the improvement will not repeat once the old layers are exhausted.

LOS 03

A US GAAP LIFO reporter must disclose the LIFO reserve, which is exactly what makes cross-company comparison possible

Because LIFO and FIFO reporters are not directly comparable on inventory-based ratios, US GAAP requires LIFO companies to disclose the LIFO reserve in the footnotes; an analyst uses this disclosure to restate a LIFO reporter to a FIFO-equivalent basis before comparing it against an IFRS peer, which can never report LIFO at all.

The trick

Authored only where a key rule has an arbitrary number, list, or formula shape worth a memory device; a module with none of those has no tricks here, on purpose.

Add the reserve to inventory, subtract the change from COGS

The two LIFO-to-FIFO formulas move in different directions: inventory gets the full reserve added; COGS gets only the period's change in the reserve subtracted. Confusing ending balance with the period's change is the most common arithmetic slip.

IFRS means no LIFO, full stop

Any question naming IFRS eliminates LIFO from consideration immediately; IAS 2 prohibits it with no grandfathering or exception.

LIFO liquidation raises profit; it does not hurt it

The word liquidation sounds bad, but the mechanical effect is a temporary, unsustainable improvement in reported gross margin from selling through old cheap inventory layers.

The method

Authored, ordered steps for answering this module's question types; a calculation module's calculator-dependent step ends with a bracketed BA II Plus keystroke sequence.

  1. Identify the price environment (rising or falling) before predicting which method gives the higher or lower COGS.
  2. For a LIFO-to-FIFO inventory conversion, add the full disclosed LIFO reserve to LIFO inventory.
  3. For a LIFO-to-FIFO COGS conversion, subtract only the change in the LIFO reserve over the period, not its ending balance.
  4. For an equity restatement, apply the after-tax multiplier, LIFO reserve times one minus the tax rate, and route the remaining tax-rate portion to a deferred tax liability.
  5. If the company reports under IFRS, eliminate LIFO as a possible method before reading further into the question.

One card

Condensed from the key rules and tricks above, nothing new. What you'd want on one index card the night before.

Practice questions

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. 10 question(s) available for this unit.

Question 1Exam level

A company uses LIFO. At year-end, its LIFO inventory is $400,000 and the LIFO reserve is $90,000. If an analyst converts the company's financials to a FIFO basis, the FIFO inventory value is closest to:

How sure are you?

Correct: C. FIFO inventory = LIFO inventory + LIFO reserve = $400,000 + $90,000 = $490,000.
A. You might subtract the LIFO reserve instead of adding it, confusing the direction of adjustment. FIFO inventory is always higher than LIFO inventory in rising prices. The reserve is added to LIFO to get FIFO.
B. You might ignore the reserve entirely and report LIFO inventory unchanged. No adjustment means no conversion. The LIFO reserve must be incorporated.

Unit: analysis-of-inventories

Question 2Exam level

A company reports LIFO COGS of $800,000. The LIFO reserve increased from $50,000 to $80,000 during the year. The FIFO-equivalent COGS is closest to:

How sure are you?

Correct: A. The correct answer is $770,000.
B. You might confuse the LIFO reserve level ($80,000) with a beginning-period figure and make no adjustment. The relevant figure is the change in LIFO reserve, not its ending balance.
C. You might add the change in LIFO reserve rather than subtract it, again getting the direction wrong. FIFO COGS is lower than LIFO COGS in rising prices. The reserve increase is subtracted.

Unit: analysis-of-inventories

Question 3Exam level

A firm purchases 100 units at $10, then 100 units at $12. It sells 150 units. Under FIFO, COGS is closest to:

How sure are you?

Correct: B. The correct answer is $1,600.
A. You might use weighted-average cost: ($10 + $12)/2 = $11 × 150 = $1,650, or miscalculates. FIFO specifies the order in which cost layers are consumed, not an average.
C. You might apply LIFO logic (sell newest first): 100 × $12 + 50 × $10 = $1,700. This is LIFO COGS, not FIFO.

Unit: analysis-of-inventories

Question 4Exam level

Under LIFO, a company's current ratio is 1.8. The LIFO reserve is $200,000, total current liabilities are $500,000. The approximate FIFO current ratio is closest to:

How sure are you?

Correct: C. The correct answer is 2.2.
A. You might forget that adding LIFO reserve to inventory increases current assets. The LIFO reserve must be added to current assets to convert to FIFO basis.
B. You might only partially adjusts or makes arithmetic error. Full LIFO reserve addition of $200,000 to $900,000 current assets yields $1,100,000 / $500,000 = 2.2.

Unit: analysis-of-inventories

Question 5Exam level

Which of the following statements about LIFO liquidation is most accurate?

How sure are you?

Correct: B. The correct answer is LIFO liquidation occurs when inventory quantities sold exceed quantities purchased, drawing down old lower-cost layers.
A. The word 'liquidation' and a method 'switch' sound related conceptually. LIFO liquidation is a physical inventory depletion event, not an accounting method change.
C. You might confuse the effect direction. LIFO normally gives higher COGS, so they assume any LIFO event reduces profit. LIFO liquidation produces the opposite effect: lower COGS from old cheap layers, resulting in temporarily higher gross profit.

Unit: analysis-of-inventories

Question 6Exam level

A company operating under IFRS is evaluating three inventory cost methods. Which method(s) is most likely the company permitted to use?

How sure are you?

Correct: B. The correct answer is FIFO and weighted-average cost.
A. You might over-restrict IFRS. They know LIFO is prohibited but forget weighted-average is also permitted. Both FIFO and weighted-average are allowed under IAS 2.
C. This is correct under US GAAP. You might confuse GAAP and IFRS rules. LIFO is prohibited under IFRS. Only US GAAP permits LIFO.

Unit: analysis-of-inventories

Question 7Exam level

During a period of rising prices, compared to a company using FIFO, a company using LIFO will most likely report:

How sure are you?

Correct: B. The correct answer is Higher COGS, lower net income, lower ending inventory.
A. This describes FIFO characteristics. You might swap the two methods. These are FIFO effects. LIFO produces the opposite in rising prices.
C. You might correctly identifies COGS and inventory effects but confuses the income effect. Higher COGS means lower gross profit, lower pre-tax income, and lower net income. Not higher.

Unit: analysis-of-inventories

Question 8Exam level

A LIFO firm's financial statements show: LIFO inventory = $600,000; LIFO reserve = $150,000; tax rate = 30%. An analyst converts the firm to a FIFO basis. The after-tax adjustment to retained earnings is closest to:

How sure are you?

Correct: A. The correct answer is $105,000.
B. You might forget to apply the tax rate, reporting the gross pre-tax LIFO reserve as the equity adjustment. The tax effect must be deducted. Higher FIFO income means higher taxes, reducing the net equity benefit.
C. You might add the tax (rather than multiplies by the after-tax complement): $150,000 + $150,000 × 0.30 = $195,000. The tax is a cost, not an addition. After-tax = pre-tax × (1 - tax rate).

Unit: analysis-of-inventories

Question 9Above the exam

A company reports under LIFO with a LIFO reserve that increased from $80,000 to $110,000 during the year, in a period of rising costs. LIFO cost of goods sold was $900,000. Combining the LIFO reserve mechanics with the FIFO-equivalent adjustment, FIFO cost of goods sold for the same year is closest to:

How sure are you?

Correct: B. FIFO COGS = LIFO COGS - the increase in the LIFO reserve during the year = $900,000 - ($110,000 - $80,000) = $900,000 - $30,000 = $870,000. In a period of rising costs, LIFO COGS is higher than FIFO COGS would be (LIFO expenses the most recent, higher-cost inventory first), so converting from LIFO to FIFO requires SUBTRACTING the change in the reserve, not adding it.
A. $930,000 adds the full ENDING LIFO reserve balance ($900,000 + $30,000, treating the change as if it were the whole reserve) rather than adding or subtracting only the CHANGE in the reserve during the year, which is the relevant adjustment for a flow measure like COGS.
C. $1,010,000 adds the change in the reserve to LIFO COGS instead of subtracting it, reversing the direction of the adjustment; in rising-cost conditions LIFO COGS is higher than FIFO COGS, so the reserve's increase must be subtracted to arrive at the lower FIFO figure.

Unit: analysis-of-inventories

Question 10Above the exam

A company switches its inventory costing method from LIFO to FIFO for external reporting purposes, in a period of steadily rising input costs. Combining the effect on cost of goods sold with the effect on the current ratio, this switch will most likely:

How sure are you?

Correct: B. Under rising costs, FIFO expenses the OLDEST (cheapest) inventory first, leaving the most recent (most expensive) purchases in ending inventory; this means FIFO COGS is LOWER and ending inventory is HIGHER than under LIFO. Since inventory is a current asset, a higher ending inventory raises current assets and therefore raises the current ratio (current assets / current liabilities), holding current liabilities constant.
A. This reverses both effects: FIFO lowers COGS relative to LIFO in a rising-cost environment (not raises it), and the resulting higher ending inventory raises, not lowers, the current ratio.
C. While it is true that TOTAL costs over the entire life of the inventory are identical under any method (methods only affect timing), that does not mean COGS and the current ratio are unaffected in ANY GIVEN YEAR; within a single period, the choice of method clearly changes both figures, which is exactly what this LOS tests.

Unit: analysis-of-inventories

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