CFA Level IFinancial Statement AnalysisEasy
During a period of steadily rising input prices, a company switches its inventory cost-flow assumption from LIFO to FIFO. Holding all else constant, which of the following best describes the effect on the company's reported ending inventory and net income relative to LIFO?
- AFIFO produces higher ending inventory and higher net income
- BFIFO produces higher cost of goods sold and lower ending inventory
- CFIFO produces lower ending inventory and higher cost of goods sold
- DFIFO produces lower cost of goods sold and lower net income
Show answer & explanationAnswer & explanation
Correct answer: A. FIFO produces higher ending inventory and higher net income
Under rising prices, FIFO assigns the oldest (lowest) costs to COGS and the newest (highest) costs to ending inventory. This lowers COGS relative to LIFO, raising both ending inventory and net income (before tax effects).
Why the other options are wrong
- B. Incorrect — FIFO gives lower COGS, not higher, in rising prices.
- C. Incorrect — FIFO ending inventory is higher, and COGS is lower.
- D. Incorrect — lower COGS raises net income, not lowers it.
FIFO vs LIFO in Rising Prices
In an inflationary environment, FIFO matches old low costs to COGS, leaving high recent costs in inventory, which raises reported inventory and net income compared to LIFO.
- FIFO: low COGS, high ending inventory, high net income in inflation
- LIFO: high COGS, low ending inventory, low net income (tax benefit) in inflation
- Effects reverse in deflationary periods
Memory trick: FIFO Flatters Financials when prices climb