CFA Level I Exam · Analyzing Income Statements

Expense Recognition and Inventory Methods for CFA Level I

Updated 7 October 2026 · Fact-checked

Expense recognition records costs in the period the related revenue or benefit is earned (the matching principle). Inventory methods (FIFO, LIFO, weighted average) decide which costs flow to COGS. Depreciation spreads asset cost over its life. To solve questions, identify the method, compute the expense, then trace the effect on profit.

Understand Expense Recognition and Inventory Methods

Under accrual accounting, you record an expense when it is incurred, not when cash is paid. The matching principle says costs should be recognised in the same period as the revenues they helped earn. Cost of goods sold (COGS) is the clearest case: the cost of an item is expensed when the item is sold.

Some costs cannot be tied to a specific sale. Salaries, rent and administrative costs are period costs and are expensed as incurred. Costs that give benefits over several periods, such as buying a machine, are capitalised (put on the balance sheet as an asset) and then expensed over time through depreciation or amortisation. Capitalising raises current profit, assets and operating cash flow compared with expensing. Expensing lowers current profit and leaves later profit higher, because there is no later depreciation charge. Total expense over the asset's life is the same; only timing differs.

When the same goods are bought at different prices, you need a cost flow assumption to split cost between COGS and ending inventory. FIFO assumes the oldest units are sold first, so ending inventory holds the latest costs. LIFO assumes the newest units are sold first, so COGS reflects recent costs. Weighted average uses the average cost per unit. When prices rise (and inventory quantity is stable or growing), FIFO gives lower COGS, higher profit and higher inventory than LIFO. In rising prices, LIFO gives lower taxable profit, where tax law allows it. IFRS prohibits LIFO; US GAAP permits it.

Depreciation allocates cost less salvage value over useful life. Straight-line gives an equal charge each year. Declining balance applies a fixed rate to the opening carrying amount, so the charge is higher early and falls over time. Units-of-production links depreciation to usage.

Many expenses rest on estimates: useful life, salvage value, bad debts, warranty costs. Longer useful lives or higher salvage values reduce depreciation and raise profit. Lower bad debt or warranty estimates also raise profit. Analysts watch for estimates that look aggressive compared with peers or past experience. Under IFRS, a change in estimate is applied prospectively, not by restating prior periods.

Key formulas to remember

Inventory identity: Ending inventory = Beginning inventory + Purchases − COGS; Rearrange to find COGS: COGS = Beginning inventory + Purchases − Ending inventory.
Straight-line depreciation: (Cost − Salvage value) ÷ Useful life; Same charge every year.
Declining balance depreciation: Rate × Opening carrying amount; double-declining rate = 2 ÷ Useful life; Salvage value is not subtracted before applying the rate, but the asset is not depreciated below salvage value.
Units-of-production depreciation: (Cost − Salvage value) ÷ Total expected units × Units produced in period; Use when wear follows usage.
Bad debt expense: Bad debt expense = Ending allowance − Beginning allowance + Write-offs charged against the allowance (net of recoveries), or Estimated % × Credit sales under the income statement approach; The roll-forward version holds when the allowance account is rolled forward: Beginning allowance + Expense − Write-offs = Ending allowance.
Rising-price rule: Rising prices: COGS LIFO > weighted average > FIFO; profit and ending inventory the reverse; Assumes stable or growing inventory quantities. Reverse the order when prices fall.

How to solve Expense Recognition and Inventory Methods questions

Use this sequence for any question on expense timing, inventory or depreciation.

1Identify what is asked: an expense amount, a profit effect, or a balance sheet value.
2Decide whether the cost is a period cost (expense now) or benefits several periods (capitalise, then depreciate).
3For inventory, list opening units and purchases in date order, then apply FIFO, LIFO or average to the units sold.
4For depreciation, write cost, salvage value and life, then compute the year-specific charge using the required method.
5For estimates, compare the new estimate with the old one and work out the effect on expense, then on profit.
6State the direction of the effect on profit, assets and taxes, and check it against the price trend or estimate change.
7Eliminate options that have the wrong direction or ignore a condition such as rising prices.

Quickest way: Direction-first elimination

When to use it: Use this for conceptual questions on FIFO vs LIFO or estimate changes, where you may not need full arithmetic.

Decide the price trend (rising or falling) and whether inventory quantity is stable.
Apply the rule: in rising prices FIFO gives the lowest COGS and highest profit.
For estimates, ask: does the change cut or raise the expense? Lower expense means higher profit now.
For depreciation, remember declining balance is higher in early years and straight-line is flat.
Remove the two options that contradict your direction, then confirm the last one.

Common mistakes in Expense Recognition and Inventory Methods

Assuming LIFO always gives lower profit.
Students memorise the rising-price result and forget the condition.
Fix: Check price direction first. In falling prices LIFO gives higher profit than FIFO.
Subtracting salvage value under declining balance before applying the rate.
Straight-line habits carry over.
Fix: Apply the rate to opening carrying amount. Only stop when carrying amount reaches salvage value.
Treating capitalising as increasing total expense over the asset's life.
Confusing timing with total amount.
Fix: Capitalising delays expense. Total expense over the life is the same; early profit and operating cash flow are higher, while investing cash outflow rises.
Using LIFO in an IFRS question.
Students forget the framework.
Fix: IFRS prohibits LIFO. Only FIFO, weighted average or specific identification apply unless the question says US GAAP.
Taking the whole allowance as bad debt expense.
Mixing the balance sheet allowance with the income statement charge.
Fix: Expense = ending allowance − beginning allowance + write-offs charged against the allowance (net of recoveries), when the allowance is rolled forward. Or use estimated % × credit sales under the income statement approach.
Restating prior years for a change in useful life.
Confusing changes in estimate with changes in accounting policy.
Fix: A change in estimate affects current and future periods only.

Worked examples

Example 1

A company starts with 100 units at €10. It buys 200 units at €12, then sells 150 units. What is COGS under FIFO? A) €1,500 B) €1,600 C) €1,800

Show the solution

FIFO sells the oldest units first: 100 units at €10 = €1,000.
The remaining 50 units come from the €12 batch: 50 × €12 = €600.
FIFO COGS = €1,000 + €600 = €1,600, which is option B.
Follow-up (not part of the question): LIFO sells all 150 units from the €12 batch: 150 × €12 = €1,800, higher than FIFO, so in rising prices LIFO COGS is higher.
With the same sales, the €200 difference in COGS (€1,800 − €1,600) means FIFO gross profit is €200 higher.

Answer: B) €1,600. Follow-up: LIFO COGS is €1,800, so for the same sales FIFO shows €200 more gross profit.

Exam tips

Always check for the words 'rising prices' and 'IFRS' or 'US GAAP' before choosing a cost flow answer.
Questions often ask about direction (higher, lower) rather than amounts; use the elimination method to save time.
Remember capitalised costs affect cash flow classification: they are shown in investing cash flow, so CFO is higher and CFI is lower (more negative) than if the cost were expensed.
For declining balance, track carrying amount and stop at salvage value in later years.
Estimate changes: ask whether the expense falls or rises, then state the effect on profit, ratios and taxes.

Practice questions from Analyzing Income Statements

Expense Recognition and Inventory Methods in other exams

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

Expense Recognition and Inventory Methods: frequently asked questions

What is the matching principle in CFA Level I?

It says expenses are recognised in the same period as the revenues they help generate. Cost of goods sold is recognised when the goods are sold. Costs not linked to specific revenue, like administration, are expensed as incurred.

How does FIFO vs LIFO affect the income statement?

In rising prices with stable or growing inventory, FIFO gives lower COGS and higher net income than LIFO. LIFO gives higher COGS and lower income. In falling prices, the effects reverse.

What is the difference between capitalising and expensing a cost?

Expensing charges the whole cost to the income statement now. Capitalising records it as an asset and spreads it over future periods through depreciation or amortisation. Capitalising raises current profit and operating cash flow, but not total lifetime expense.

How do bad debt and warranty estimates affect earnings?

Both are estimated expenses recognised when revenue is recorded. Underestimating them raises current profit and later forces larger charges. Analysts compare the estimates with past experience and peers to spot aggressive reporting.