Inventory Valuation Methods (LIFO, FIFO)

One of the most-tested accounting choices on Series 6 is the inventory valuation method. The method changes Cost of Goods Sold (COGS), reported earnings, inventory on the balance sheet, and taxes. The exam tests the effects in a rising-price environment.

What is the purpose of inventory valuation?

• Inventory valuation determines how a company measures the cost of goods sold (COGS) on the income statement and the inventory balance on the balance sheet
• U.S. Generally Accepted Accounting Principles (GAAP) permit First-In, First-Out (FIFO), Last-In, First-Out (LIFO), weighted-average cost, and specific identification; the Series 6 outline names LIFO and FIFO specifically
• The method chosen is disclosed in the accounting-policies footnote
• Once chosen, the company generally keeps it; any change requires disclosure and tax-authority approval

Exam Tip: Gotchas

• The method is disclosed in the accounting-policies footnote. Two otherwise identical companies using different inventory methods will report different earnings and taxes without any difference in their actual operations.
• A change in method is not a free choice. It requires disclosure and tax-authority approval. The exam treats the method as sticky once chosen.

What is FIFO inventory valuation?

• Assumes the oldest inventory (first purchased or manufactured) is sold first
• COGS reflects older costs
• Ending inventory on the balance sheet reflects newer (most recent) costs
• In a rising-price environment: COGS is lower (older, cheaper costs expensed), reported earnings are higher, inventory on the balance sheet is higher, and taxes are higher

Memory Aid: FIFO follows the older prices to COGS (first in, first out means the oldest units leave first).

Exam Tip: Gotchas

• Under FIFO in rising prices, reported earnings look stronger but the tax bill is bigger. Balance-sheet inventory holds the newer, higher costs, so both the income statement and the balance sheet look more flattering than LIFO would show.
• FIFO is permitted under both U.S. GAAP and IFRS. A company switching to IFRS can keep FIFO; it cannot keep LIFO.

What is LIFO inventory valuation?

• Assumes the newest inventory (most recently purchased or manufactured) is sold first
• COGS reflects newer costs
• Ending inventory on the balance sheet reflects older (often cheaper) costs
• In a rising-price environment: COGS is higher (newer, more expensive costs expensed), reported earnings are lower, inventory on the balance sheet is lower, and taxes are lower

Memory Aid: LIFO follows the newer prices to COGS (last in, first out means the newest units leave first).

Exam Tip: Gotchas

• LIFO is prohibited under IFRS. A company that files IFRS financial statements cannot use LIFO. U.S. GAAP permits both.
• The "LIFO reserve" disclosed in footnotes quantifies the difference between LIFO-reported inventory and what FIFO would have shown. Analysts use it to compare LIFO and FIFO filers on equal footing.

How do FIFO and LIFO compare in a rising-price environment?

• In falling prices, the effects reverse: FIFO produces lower earnings and taxes; LIFO produces higher earnings and taxes
• LIFO is a U.S. GAAP option only; it is not permitted under International Financial Reporting Standards (IFRS)
• International companies and U.S. companies that file IFRS cannot use LIFO

Exam Tip: Gotchas

• When prices are rising, FIFO produces higher earnings and LIFO produces lower earnings. The reverse holds when prices are falling. Memorize the direction first, then the follow-on effects on taxes and balance-sheet inventory.
• LIFO produces lower taxes in a rising-price environment. This is the main economic reason companies choose it.
• The Series 6 outline names LIFO and FIFO. Know both and their price-direction effects. Weighted-average and specific identification are GAAP-permitted but not tested here.