CFA Level I · CFA Level I Exam

Analysis of Inventories for CFA Level I

Analysis of inventories covers how companies measure inventory cost, choose a cost flow method (FIFO, LIFO, weighted average), and report write-downs. You solve questions by tracking units and costs, finding cost of goods sold, adjusting LIFO to FIFO with the LIFO reserve, and then comparing ratios across firms.

What this chapter covers

This chapter explains how a company turns the cost of goods it buys or makes into two numbers: inventory on the balance sheet and cost of goods sold (COGS) on the income statement. The link is simple: opening inventory + purchases (or production costs) = COGS + closing inventory. Every method in the chapter is a different rule for splitting that total.

You first learn what goes into inventory cost and how inventory is measured at the lower of cost and net realisable value (IFRS). Then you learn the cost flow methods. FIFO assumes the oldest costs leave first. Weighted average uses an average cost. LIFO assumes the newest costs leave first. LIFO is allowed under US GAAP but not under IFRS. Financial reporting questions use IFRS unless a question says US GAAP, so read the stem for this.

The chapter connects to the rest of Financial Statement Analysis. Inventory choices change profit, taxes, working capital and ratios, so they matter when you compare firms in later chapters on income statements, balance sheets, cash flows and financial analysis techniques. It also feeds Corporate Finance (working capital) and Equities (earnings quality).

Financial Statement Analysis carries a 11-14% weight in the 2027 curriculum, and inventories is one of its most calculable chapters. The questions are short, rule-based and numerical, so careful practice turns them into reliable marks. With three-option questions and no penalty for wrong answers, you can often eliminate two options once you know the direction of an effect, such as what rising prices do to LIFO versus FIFO profit. The ideas also help you in later chapters where inventory methods distort comparisons.

Analysis of Inventories: topics in the order to study them

1Inventory Cost Measurement and ValuationStart here because you must know what counts as inventory cost and how the lower of cost and net realisable value idea works before you apply any method.
2Inventory Cost Flow Methods: FIFO, LIFO, Weighted AverageThis is the core calculation skill; every later topic builds on computing COGS and ending inventory under each method.
3LIFO Reserve and Converting LIFO to FIFOIt needs the cost flow methods first, because the reserve is the gap between FIFO and LIFO inventory.
4Inventory Write-Downs and ReversalsOnce you know cost, you can test it against net realisable value and see how write-downs and reversals hit profit. The key difference between IFRS and US GAAP is whether reversals are allowed.
5Inventory Ratios and Financial Statement AnalysisFinish with analysis, because ratios such as inventory turnover only make sense once you understand how the underlying numbers are produced and adjusted.

How to prepare Analysis of Inventories

Aim to be fast and accurate on the calculations, and clear on the direction of every effect. Work with a pen and a simple table rather than only reading.

Read the cost rules first and list what is included (purchase price, conversion costs, other costs to bring inventory to its location and condition) and what is excluded (such as abnormal waste and selling costs).
Practise one small data set under all three methods. Use the same purchases for FIFO, LIFO and weighted average, and check that opening inventory + purchases = COGS + ending inventory each time.
Build a rising-price and falling-price table showing which method gives higher COGS, profit, tax and ending inventory. Memorise the pattern, then test it on examples.
Learn the LIFO reserve conversions: FIFO inventory = LIFO inventory + LIFO reserve, and FIFO COGS = LIFO COGS − change in LIFO reserve. Practise with the effect on retained earnings and taxes.
Drill write-downs and reversals separately for IFRS and US GAAP. Note when reversals are allowed, and where the loss is recognised.
Calculate inventory turnover, days of inventory on hand and gross margin before and after adjustments, and say in one sentence what the change means.
Finish with timed mixed sets of three-option questions at about 90 seconds each, and review every miss by naming the rule you broke.

Common mistakes in Analysis of Inventories

Applying LIFO to an IFRS question.
Fix: Check the stem for IFRS or US GAAP. If the question is IFRS, LIFO is not an allowed method.
Getting the sign wrong when converting COGS from LIFO to FIFO.
Fix: Use the logic: if the reserve rises, FIFO profit is higher, so FIFO COGS is lower. That gives FIFO COGS = LIFO COGS − change in reserve.
Forgetting tax and retained earnings effects of LIFO adjustments.
Fix: Convert the reserve to its after-tax effect when asked. Multiply the reserve by (1 − tax rate) for the effect on equity, and note the extra tax liability.
Mixing up IFRS and US GAAP write-down rules.
Fix: Keep a two-column note and revise it often. IFRS uses the lower of cost and NRV for all inventory. US GAAP uses the lower of cost and NRV for FIFO and weighted average, and the lower of cost or market for LIFO and the retail method. On reversals, IFRS allows them (up to the original write-down) and US GAAP does not.
Using ending inventory instead of average inventory in turnover.
Fix: Use average inventory unless the question says otherwise. State the formula before you substitute.
Comparing ratios across firms without adjusting to the same method.
Fix: Convert LIFO firms to FIFO using the reserve first, then compare turnover, margins and current ratio.

Last-day revision: Analysis of Inventories

Opening inventory + purchases = COGS + ending inventory.
Inventory cost includes purchase cost, conversion costs and other costs to bring it to its present location and condition.
Selling costs, abnormal waste and storage costs not needed in production are expensed, not capitalised.
Under IFRS, all inventory is carried at the lower of cost and net realisable value.
Under US GAAP, FIFO and weighted average inventory use the lower of cost and NRV; LIFO and the retail method use the lower of cost or market.
FIFO: oldest costs go to COGS, newest stay in inventory.
LIFO: newest costs go to COGS; it is not permitted under IFRS.
In rising prices with stable or growing inventory, LIFO gives higher COGS, lower profit and lower tax than FIFO.
FIFO inventory = LIFO inventory + LIFO reserve.
FIFO COGS = LIFO COGS − change in LIFO reserve (ending reserve − beginning reserve).
IFRS permits reversal of write-downs, limited to the original write-down; US GAAP does not permit reversals.
Inventory turnover = COGS ÷ average inventory; days of inventory on hand = 365 ÷ inventory turnover.
Adjust to a common method before comparing firms that use different cost flow methods.

Analysis of Inventories practice questions

Analysis of Inventories in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Analysis of Inventories: frequently asked questions

Is LIFO allowed under IFRS?

No. IFRS does not permit LIFO. It is allowed under US GAAP, so questions on LIFO will be set in a US GAAP context or as an analysis of a US GAAP company.

How do I convert LIFO inventory to FIFO?

Add the LIFO reserve to LIFO inventory. The reserve is the amount by which FIFO inventory exceeds LIFO inventory. For COGS, subtract the change in the reserve from LIFO COGS to get FIFO COGS.

Can an inventory write-down be reversed?

Under IFRS, yes: a reversal is allowed if net realisable value recovers, but only up to the original write-down. Under US GAAP, a write-down creates a new cost basis and is not reversed.

Do I need a calculator for this chapter?

Most questions need only basic arithmetic, and you can use your approved TI BA II Plus or HP 12C. Your main task is to set up the numbers correctly, not to use special functions.