Updated for the 2026-2027 CFA® Level I curriculum.
Two companies can sell the exact same units and report different profits, simply because one uses FIFO and the other uses LIFO. When prices rise or fall, these methods pull different costs into cost of goods sold and leave different costs sitting in ending inventory. CFA Level I tests whether you can calculate this gap and explain what it means for ratios like gross margin, the current ratio, and inventory turnover.
Quick Answer
Assuming no liquidation and comparable inventory quantities, under inflation FIFO reports higher ending inventory and higher net income than LIFO, because FIFO matches older, cheaper costs against revenue. LIFO reports higher cost of goods sold and lower net income, but lower taxes and more cash. The LIFO reserve, disclosed in the footnotes, converts LIFO figures to a FIFO basis so analysts can compare companies on equal terms. Deflation reverses every one of these effects.
Key Takeaways
Inflation raises FIFO inventory and net income above LIFO figures, because FIFO leaves the newest, pricier costs sitting in ending inventory.
LIFO produces higher cost of goods sold and lower net income during inflation, which lowers current tax expense and preserves cash.
The LIFO reserve equals FIFO inventory minus LIFO inventory, and it typically grows each year prices rise.
Analysts use the LIFO reserve to restate a LIFO company's inventory, COGS, and net income to a FIFO basis for fair comparison.
A LIFO liquidation happens when inventory quantities fall and old, low-cost layers flow into COGS, temporarily inflating gross margin and net income.
Deflation flips every effect above: LIFO shows higher income and inventory, FIFO shows higher COGS.
What You Need to Know for CFA Level I
The LOS asks you to calculate and explain inflation and deflation effects on statements and ratios, not just define FIFO and LIFO.
You must know the LIFO reserve formula and use it to convert LIFO inventory, COGS, and net income to FIFO equivalents.
You need to recognize a LIFO liquidation from a shrinking LIFO reserve and explain why it distorts gross margin.
This note does not cover how a company chooses an inventory method or how inventory is tested against net realizable value. Those concepts live in sibling notes.
The most common exam trap is reversing direction: mixing up which method shows higher income, higher inventory, or higher cash under inflation.
How Rising and Falling Prices Flow Through Inventory Costs
Inventory costing methods assign costs to COGS in a specific order. FIFO assumes the oldest costs leave first. LIFO assumes the newest costs leave first. When prices move, this ordering creates a real, calculable gap between the two methods.
Inflation: Rising Prices
Under FIFO, the oldest, cheaper costs hit COGS first. That leaves the newest, more expensive costs in ending inventory. Reported inventory looks larger, and COGS looks smaller, so gross profit and net income look higher than they would under LIFO.
Under LIFO, the newest, pricier costs hit COGS first. Ending inventory holds the oldest, cheaper costs, so it looks smaller on the balance sheet. COGS looks larger, and net income looks smaller than FIFO's.
Item (rising prices) | FIFO | LIFO |
|---|---|---|
Ending inventory | Higher | Lower |
Cost of goods sold | Lower | Higher |
Gross profit and net income | Higher | Lower |
Income tax expense | Higher | Lower |
Cash flow (after tax) | Lower | Higher |
Current ratio | Higher | Lower |
Inventory turnover | Lower | Higher |
Deflation: Falling Prices
Under sustained falling costs and comparable inventory quantities, the usual FIFO-LIFO differences reverse. Layer composition, liquidation, and tax assumptions can alter the result. FIFO releases the oldest, higher costs into COGS first, so FIFO shows lower net income, lower inventory, and lower taxes than LIFO. LIFO releases the newest, cheaper costs too, but into COGS under its own sequencing, which now produces higher net income, higher inventory, and higher taxes than FIFO.
The core exam skill is not memorizing the table. It is tracing the logic: which costs leave the shelf first, and what does that do to COGS, inventory, income, and cash.
The LIFO Reserve and Why It Exists
A company that reports under LIFO still needs to disclose enough data for analysts to see what its numbers would look like under FIFO. That disclosure is the LIFO reserve.
The LIFO reserve rises when prices rise, because FIFO inventory pulls further ahead of LIFO inventory each year. It shrinks, or can turn negative, during deflation. A shrinking reserve combined with falling inventory quantities often signals a LIFO liquidation, covered next.
LIFO Liquidation: When Inventory Quantities Drop
A LIFO liquidation happens when a company sells more units than it purchases or produces during the period. Inventory quantities fall, so the company has to dip into old, low-cost LIFO layers that it normally would not touch.
During inflation, those old layers carry much lower costs than current replacement costs. Pulling them into COGS makes COGS look artificially low for that period. Gross margin and net income spike upward, but the spike is not sustainable. The company is essentially selling inventory it bought years ago at old prices, and it cannot repeat that trick once those layers run out.
Two warning signs point to a liquidation:
Inventory quantities (units) decline in the footnotes.
The LIFO reserve shrinks instead of growing, even though prices are still rising.
Analysts normalize earnings when a liquidation occurs, because the reported margin does not reflect the company's ongoing cost structure. It also tends to increase taxable income and current tax expense for that period, since the gain is real for tax purposes even though it will not repeat.
LIFO Reserve and FIFO Conversion Formulas
LIFO Reserve = InventoryFIFO - InventoryLIFO
InventoryFIFO: inventory value the company would report if it used FIFO
InventoryLIFO: inventory value as actually reported under LIFO
Converting COGS to a FIFO basis:
COGSFIFO = COGSLIFO - (LIFO Reserveend - LIFO Reservebeg)
Converting net income to a FIFO basis:
Net IncomeFIFO = Net IncomeLIFO + (LIFO Reserveend - LIFO Reservebeg) × (1 - t)
Converting retained earnings to a FIFO basis:
Retained EarningsFIFO = Retained EarningsLIFO + LIFO Reserveend × (1 - t)
Estimating the cumulative cash effect:
CashFIFO = CashLIFO - t × LIFO Reserveend
where:
: the company's income tax rate,
LIFO Reserveend: LIFO reserve at the end of the current period, and
LIFO Reservebeg: LIFO reserve at the start of the current period (same as prior year-end).
The COGS and net income conversions use the change in the reserve, not the ending balance. The retained earnings and cash conversions use the ending balance, because they reflect a cumulative effect built up over time.
Working Example
Granite Supply Co. uses LIFO. Prices for its raw materials rose steadily all year.
LIFO reserve, start of year: $60,000
LIFO reserve, end of year: $90,000
Reported COGS under LIFO: $2,000,000
Reported net income under LIFO: $450,000
Tax rate: 25%
Calculate Granite's COGS and net income on a FIFO basis, and estimate the cash difference between the two methods.
Step 1: Find the change in the LIFO reserve.
$90,000 - $60,000 = $30,000
Step 2: Convert COGS to a FIFO basis.
COGSFIFO = $2,000,000 - $30,000 = $1,970,000
Step 3: Convert net income to a FIFO basis.
Net IncomeFIFO = $450,000 + $30,000 × (1 - 0.25) = $450,000 + $22,500 = $472,500
Step 4: Estimate the cash effect.
CashFIFO = CashLIFO - 0.25 × $90,000 = CashLIFO - $22,500
Because prices rose and the reserve grew, Granite's LIFO figures understate what its profit would look like under FIFO by $22,500. An analyst comparing Granite to a FIFO competitor should use the $472,500 figure, not the reported $450,000, to make a fair comparison.
At the same time, At a constant 25% tax rate, the ending reserve implies a hypothetical cumulative tax cash difference of $22,500. This year's reserve increase implies a $7,500 tax cash difference. These are counterfactual tax effects; a reporting adjustment to FIFO does not itself change actual cash.
Common Exam Traps
Reversing the inflation direction
Candidates often assume LIFO shows higher net income during inflation. In rising prices, LIFO expenses the newest, pricier costs first, so LIFO net income is lower than FIFO's, not higher.
Forgetting the tax adjustment in the net income conversion
The change in the LIFO reserve must be multiplied by (1 - t) before it is added to net income. Adding the full reserve change without the tax adjustment overstates the FIFO figure.
Treating a LIFO liquidation gain as repeatable
A liquidation produces a one-time boost to margin and income. Candidates who extend that spike into future periods misjudge the company's normal profitability.
Confusing the LIFO reserve with the inventory method choice
The LIFO reserve is a reconciling disclosure, not a separate valuation method. This note covers inflation and comparability effects only. Method selection and NRV testing belong to other notes in this topic.
Using the ending reserve instead of the change in reserve for COGS
The COGS conversion depends on the change in the LIFO reserve over the period. Using the ending balance alone produces the wrong adjustment.
Practice Question
Baxter Mills reports LIFO ending inventory of $180,000 and cost of goods sold of $1,240,000 for the year. The LIFO reserve was $40,000 at the beginning of the year and $70,000 at year end. Prices rose steadily throughout the year. Baxter's cost of goods sold on a FIFO basis is closest to:
$1,210,000
$1,270,000
$1,240,000
Correct Answer: A
The change in the LIFO reserve is $70,000 - $40,000 = $30,000. COGS on a FIFO basis equals LIFO COGS minus the change in the reserve: $1,240,000 - $30,000 = $1,210,000.
Option B: This reverses the sign, adding the change in the reserve instead of subtracting it. This mistake assumes LIFO understates COGS during inflation, which is backwards.
Option C: This uses the unadjusted LIFO figure and ignores the conversion entirely, missing the inflation effect the question is testing.
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FAQs About Inflation and Deflation Effects on Inventory, Financial Statements, and Ratios
What is the LIFO reserve formula?
The LIFO reserve equals FIFO inventory minus LIFO inventory. It shows how much higher inventory would be if the company used FIFO instead of LIFO, and it is disclosed in the inventory footnote.
What triggers a LIFO liquidation?
A LIFO liquidation happens when a company sells more units than it buys or produces during the period, so inventory quantities fall. Old, low-cost layers get pulled into COGS, temporarily inflating gross margin during inflation.
How do you convert a company's financial statements from LIFO to FIFO?
You use the LIFO reserve and its change over the period. Add the ending reserve to LIFO inventory, subtract the change in the reserve from LIFO COGS, and add the after-tax change in the reserve to LIFO net income.
If inventory is overstated, what happens to net income?
If ending inventory is overstated, COGS is understated by the same amount, since COGS equals beginning inventory plus purchases minus ending inventory. Lower COGS means higher reported net income for that period.
Does the LIFO reserve disappear during deflation?
It can shrink toward zero or turn negative during sustained deflation, since FIFO inventory would then sit below LIFO inventory. A shrinking reserve during a period of rising prices instead usually signals a LIFO liquidation.