CFA Level I Exam · Analysis of Inventories

LIFO Reserve and Converting LIFO to FIFO

Q: What is the LIFO reserve?

It is the difference between FIFO inventory and LIFO inventory, disclosed by US GAAP companies that use LIFO. It is a cumulative amount. Add it to LIFO inventory to get FIFO inventory.

Q: How do I convert LIFO COGS to FIFO COGS?

Subtract the change in the LIFO reserve from LIFO COGS. Change means ending reserve minus beginning reserve. If the reserve fell, the result is that FIFO COGS is higher than LIFO COGS, and you must calculate the effect on inventory turnover instead of assuming it.

Q: What is the effect of LIFO liquidation on profit?

In rising prices, selling old low-cost layers cuts COGS and raises reported profit. The LIFO reserve falls in the year. The extra profit is temporary, so analysts look through it with FIFO figures.

Q: Why does the tax rate matter when converting to FIFO?

Higher FIFO income would be taxed more. Net income rises by the change in reserve × (1 − t), and equity rises by the ending reserve × (1 − t). The tax part, reserve × t, is treated as an additional liability (deferred tax) in the analyst's adjustment, assuming a constant tax rate.

Updated 7 October 2026 · Fact-checked

The LIFO reserve is the amount by which FIFO inventory exceeds LIFO inventory. To convert LIFO to FIFO, add the reserve to inventory, subtract the year's increase in the reserve from COGS, and adjust tax and equity using the tax rate. This makes companies using different inventory methods comparable.

Understand LIFO Reserve and Converting LIFO to FIFO

Inventory cost flow methods give different numbers from the same physical goods. When prices rise, LIFO (last-in, first-out) sends the newest, higher costs to cost of goods sold (COGS) and leaves older, lower costs on the balance sheet. FIFO (first-in, first-out) does the opposite. So LIFO shows higher COGS, lower profit and lower inventory than FIFO.

LIFO is allowed under US GAAP but prohibited under IFRS. So when you compare a US GAAP company on LIFO with an IFRS company on FIFO, you must put them on the same basis. The standard choice is to convert LIFO to FIFO, because FIFO inventory is closer to current cost.

US GAAP companies that use LIFO must disclose the LIFO reserve. It is the cumulative difference between FIFO inventory and LIFO inventory: LIFO reserve = FIFO inventory − LIFO inventory. In a period of rising costs and stable or growing inventory, the reserve grows each year. The change in the reserve over the year is the difference between FIFO COGS and LIFO COGS.

A LIFO liquidation happens when a company sells more units than it buys, so it dips into old, low-cost layers. In rising prices, those old costs flow into COGS, COGS falls, and profit rises. The gain is temporary and not from operations. The LIFO reserve falls in a liquidation year. Analysts remove this effect by looking at FIFO figures.

The reserve also affects tax. LIFO gives lower taxable income in rising prices, so tax paid is lower. When you move to FIFO, extra income is taxed, so adjust for the tax rate.

In the analyst's adjustment, the reserve increases assets. The after-tax part (reserve × (1 − t)) increases equity, and the tax part (reserve × t) is treated as an additional liability (deferred tax). This is the analyst's adjustment, not necessarily something the company has recognised. The equity split assumes the tax rate is constant.

Key formulas to remember

FIFO inventory: Inventory (FIFO) = Inventory (LIFO) + LIFO reserve; Use the reserve at the same date as the inventory. Apply it to both beginning and ending inventory when you need an average.
FIFO COGS: COGS (FIFO) = COGS (LIFO) − (Ending LIFO reserve − Beginning LIFO reserve); Rising reserve means FIFO COGS is lower. Falling reserve (liquidation) means FIFO COGS is higher than LIFO COGS.
Pretax income effect: Pretax income (FIFO) = Pretax income (LIFO) + Change in LIFO reserve; Same amount as the COGS difference, with the opposite sign.
After-tax income effect: Net income (FIFO) = Net income (LIFO) + Change in LIFO reserve × (1 − t); t is the tax rate. The tax payable rises when income rises.
Equity adjustment: Equity (FIFO) = Equity (LIFO) + Ending LIFO reserve × (1 − t); Uses the cumulative reserve, not the annual change.
Deferred tax effect: Additional liability (deferred tax, analyst's adjustment) = Ending LIFO reserve × t; The reserve increases assets. The after-tax part, reserve × (1 − t), increases equity. The tax part, reserve × t, is treated as an additional liability in the analyst's adjustment, not necessarily one the company recognises. This assumes a constant tax rate.
Inventory turnover on FIFO basis: Inventory turnover (FIFO) = COGS (FIFO) ÷ Average FIFO inventory; Adjust both numerator and denominator. Turnover falls after conversion when the reserve rises, because COGS falls while inventory rises. If the reserve falls, FIFO COGS is higher and FIFO inventory is also higher, so calculate the result rather than assume the direction.

How to solve LIFO Reserve and Converting LIFO to FIFO questions

Use this order for any question that gives LIFO figures and a LIFO reserve and asks for a FIFO number or ratio.

1Identify what the question wants: inventory, COGS, income, equity, a ratio, or the effect of a liquidation.
2Write down the LIFO reserve at each date given. Note whether it rose or fell, and the tax rate if given.
3Convert inventory: add the reserve at each date to LIFO inventory at that date.
4Convert COGS: subtract the change in reserve (ending minus beginning) from LIFO COGS. A negative change raises COGS.
5Convert income: pretax income changes by the change in reserve. Multiply by (1 − t) for net income.
6Convert equity: add ending reserve × (1 − t). The tax part, reserve × t, is treated as a liability in the analyst's adjustment.
7Recalculate any ratio, such as current ratio, inventory turnover or gross margin, using only adjusted figures.
8Check direction: in rising prices with a rising reserve, FIFO gives higher inventory, higher income, higher equity, lower COGS and lower turnover. If the reserve falls, FIFO COGS is higher, so calculate turnover instead of assuming its direction.

Quickest way: Direction first, then arithmetic

When to use it: Use under time pressure on three-option MCQs, where checking the direction can often eliminate two options.

Decide if prices are rising. If so, FIFO inventory > LIFO inventory, FIFO COGS < LIFO COGS (when the reserve rises).
Use the reserve for balance sheet items and the change in reserve for income statement items.
Compute with one line: FIFO COGS = LIFO COGS − change in reserve. Eliminate any option moving the wrong way.
For equity, remember the reserve × (1 − t). Do not use the reserve alone if a tax rate is given.
For ratios, on the BA II Plus type the numerator, press ÷, type the denominator, press =. Use full precision, then round at the end.

Common mistakes in LIFO Reserve and Converting LIFO to FIFO

Using the ending reserve instead of the change in reserve to adjust COGS.
Both inventory and COGS adjustments involve the reserve, so students use the same number for both.
Fix: Balance sheet items use the level of the reserve. Income statement items use the change in the reserve over the period.
Adding the change in reserve to COGS instead of subtracting it.
Students think a bigger inventory means bigger COGS.
Fix: A rising reserve means FIFO profit is higher, so FIFO COGS is lower. Subtract the increase.
Ignoring tax when adjusting net income or equity.
The reserve adjustment looks complete before the tax rate is applied.
Fix: If a tax rate is given, multiply the change in reserve by (1 − t) for net income, and the ending reserve by (1 − t) for equity. The remainder is tax.
Adjusting only COGS for turnover and leaving inventory on a LIFO basis.
Students stop after the first conversion.
Fix: Convert both beginning and ending inventory to FIFO, average them, and divide FIFO COGS by that average.
Treating LIFO liquidation profit as a sign of better operations.
COGS falls and margin rises, which looks like efficiency.
Fix: In rising prices, a reserve drop signals old low-cost layers were sold. The profit is not repeatable. Remove it by using FIFO figures.
Applying the conversion when prices are falling and expecting the same direction.
The rule is memorised as 'FIFO is always higher'.
Fix: Rely on the sign of the reserve, not memory. The reserve is FIFO inventory minus LIFO inventory, so the arithmetic handles either case.

Worked examples

Example 1

A US GAAP company uses LIFO. LIFO COGS for the year is $1,800 million. The LIFO reserve was $60 million at the start of the year and $75 million at the end. The tax rate is 25%. What is COGS on a FIFO basis, in $ million? A) 1,785 B) 1,800 C) 1,815

Show the solution

Change in reserve = 75 − 60 = 15.
FIFO COGS = LIFO COGS − change in reserve = 1,800 − 15 = 1,785.
Check direction: the reserve rose, so FIFO profit is higher and FIFO COGS is lower. This eliminates 1,815 and 1,800.
Related effect: pretax income rises by 15, and net income rises by 15 × (1 − 0.25) = 11.25.

Answer: A) $1,785 million.

Example 2

Using the same company, LIFO inventory is $400 million at the start of the year and $420 million at the end. LIFO COGS is $1,800 million, and the reserve is $60 million at the start and $75 million at the end. What is inventory turnover on a FIFO basis? A) 3.74 B) 4.35 C) 4.39

Show the solution

FIFO beginning inventory = 400 + 60 = 460.
FIFO ending inventory = 420 + 75 = 495.
Average FIFO inventory = (460 + 495) ÷ 2 = 477.5.
FIFO COGS = 1,800 − (75 − 60) = 1,785.
Turnover = 1,785 ÷ 477.5 = 3.738, which rounds to 3.74.
Check: LIFO turnover is 1,800 ÷ 410 = 4.39, which is option C. It uses LIFO COGS and average LIFO inventory of (400 + 420) ÷ 2 = 410, with no FIFO adjustment. The reserve rose, so FIFO turnover is lower than LIFO turnover. B (1,785 ÷ 410 = 4.35) uses FIFO COGS with LIFO inventory, which mixes bases.

Answer: A) 3.74 times.

Exam tips

Questions often give the reserve for two dates. Read carefully which one the question needs: level for the balance sheet, change for the income statement.
Direction checks eliminate options fast. In rising prices with a rising reserve, FIFO inventory, income and equity are higher, and COGS and turnover are lower.
Watch for a falling reserve. This signals LIFO liquidation or falling prices, and FIFO COGS will then be higher than LIFO COGS. Do not assume the direction of turnover in that case; calculate it.
Do not mix bases. If you convert COGS, convert inventory too before computing ratios.
Questions are worded as comparisons between companies. Remember that IFRS bans LIFO, so the LIFO company is a US GAAP reporter.

Practice questions from Analysis of Inventories