CPA Inventory Notes: LIFO, FIFO and Lower of Cost or NRV [FAR Guide]

CPA inventory notes start with one rule: inventory stays at cost until a later test forces a write-down. Under ASC 330, a company first picks a cost flow method: FIFO, LIFO, or average cost. It applies the method consistently, and then measures inventory at the lower of cost or net realizable value. In contrast, LIFO and retail method inventory are the exceptions and still use lower of cost or market. As a result, the method changes cost of goods sold, gross profit, and taxes in a rising price period. For the full CPA study collection, see the CPA notes hub.

Overall, inventory sits in FAR Area II, Select Balance Sheet Accounts, at 30 to 40 percent of the section. In addition, the AICPA Blueprints test it in group FAR.II.C under ASC 330, at the Application and Analysis skill levels.

CPA Inventory Notes: What ASC 330 Covers

In summary, under ASC 330, inventory starts at cost and each period brings a fresh test. FIFO and average cost inventory stays at the lower of cost or net realizable value. LIFO and retail method inventory use lower of cost or market, with a ceiling and floor capping replacement cost.

For example, ASC 330 covers raw materials, work in process, finished goods, and merchandise held for sale. Inventory cost means all costs to bring an item to its present location and condition. These costs include purchase price, freight-in, import duties, and handling. However, companies expense abnormal waste, post-production storage, selling costs, and general administration. Finally, ASC 330-10-30-9 allows FIFO, average cost, or LIFO. The method is a cost flow assumption, not a record of which units physically left the warehouse.

CPA Inventory Notes: FIFO, LIFO and Average Cost

Worked Example 1 runs all three methods on the same facts. First, a retailer starts the year with 100 units at $10 each. It then buys 200 units at $12 in March, and 200 units at $15 in September. Overall, goods available for sale are 500 units at $6,400. Finally, the retailer sells 300 units at $25 each, for sales of $7,500, and holds 200 units at year end.

Method	COGS	Ending inventory	Gross profit
FIFO	$3,400	$3,000	$4,100
LIFO	$4,200	$2,200	$3,300
Weighted average	$3,840	$2,560	$3,660

FIFO takes the oldest costs first. For example, 100 units at $10 plus 200 units at $12 gives $3,400 of cost of goods sold. The result leaves 200 units at $15, or $3,000, in ending inventory, for gross profit of $4,100. LIFO reverses the order. In contrast, 200 units at $15 plus 100 units at $12 gives $4,200 of cost of goods sold. The result leaves 100 units at $10 plus 100 units at $12, or $2,200, for gross profit of $3,300.

Under weighted average, divide $6,400 by 500 units to get an average cost of $12.80 per unit. Cost of goods sold is 300 units at $12.80, or $3,840. Ending inventory is 200 units at $12.80, or $2,560, and gross profit is $3,660. A periodic system computes this average once at period end. In contrast, a perpetual system recalculates it after every purchase.

CPA Inventory Notes: Lower of Cost or NRV and LCM

FASB issued ASU 2015-11 in July 2015. For FIFO or average cost inventory, it replaced lower of cost or market with lower of cost or net realizable value. The change took effect for fiscal years beginning after December 15, 2016. However, LIFO and retail method inventory still use lower of cost or market.

For example, net realizable value is the estimated selling price less reasonably predictable costs of completion, disposal, and transportation. Next, Worked Example 2 applies both tests. First, Part A is a FIFO item: 400 units at $50 each, or $20,000. Therefore, selling price $52 less $4 to complete less $3 to sell gives net realizable value of $45 per unit. The write-down is $5 per unit times 400 units, or $2,000, so the item stays at $18,000.

Part B is a LIFO item, so the market test applies. The cost is 300 units at $60 each, or $18,000, and replacement cost is $55. Selling price $70 less $5 to complete less $5 to sell gives a ceiling of $60. Less a normal profit margin of $8, the floor is $52. Therefore, market is replacement cost of $55, inside the ceiling and floor. The write-down is $5 per unit times 300 units, or $1,500, so the item stays at $16,500. Overall, the total write-down is $3,500.

In short, above the ceiling, market is the ceiling; below the floor, market is the floor. A write-down under US GAAP creates a new cost basis. Companies cannot mark it back up, even when prices recover. In contrast, IAS 2 requires reversal, up to the original cost, when net realizable value recovers.

Dollar-Value LIFO, LIFO Reserve and LIFO Liquidation

Dollar-value LIFO pools inventory by dollar value and measures changes with a price index. First, convert ending inventory at current cost to base year dollars. Next, price any increase as a new layer at the current index. Finally, remove the newest layers first when the base year amount falls.

A company adopts dollar-value LIFO in 2024 with base year inventory of $100,000, index 1.00. At the end of 2025, ending inventory at current cost is $132,000 and the cumulative index is 1.10. Divide $132,000 by 1.10 to get base year cost of $120,000. The $20,000 increase prices as a new layer of $22,000. As a result, ending inventory is $122,000 and the LIFO reserve is $10,000.

The LIFO reserve is the gap between inventory at FIFO cost and at LIFO cost. In Worked Example 1, that gap is $3,000 less $2,200, or $800. It is the same $800 that separates LIFO and FIFO cost of goods sold. The change in the reserve flows through cost of goods sold. In addition, companies must disclose the reserve.

A LIFO liquidation happens when a company sells more inventory than it replaces and dips into old, low cost layers. As a result, cost of goods sold drops, reported income jumps, and the tax bill follows. Therefore, companies must disclose the effect on income. Internal Revenue Code Section 472 sets a conformity rule. A company that uses LIFO on its tax return must also use LIFO in its primary financial statements. It elects LIFO by filing Form 970. IFRS bans LIFO under IAS 2.

What Counts as Inventory: FOB Terms, Consignment and Costs

Inventory is about ownership, not location. Goods in transit belong to the buyer under FOB shipping point. Ownership passes when the goods leave the seller. The buyer records the purchase and the inventory even though the goods have not arrived. In contrast, under FOB destination, ownership passes only on delivery, so the seller keeps the goods in inventory until they arrive. Consigned goods stay in the consignor inventory, never the consignee inventory. Similarly, goods shipped on approval stay in the seller inventory until the customer accepts them.

The retail inventory method estimates ending inventory cost from retail prices using a cost to retail ratio. Companies use it when physical counts are impractical. The conventional retail method applies lower of cost or market. In contrast, the FIFO retail method applies lower of cost or net realizable value.

Inventory Errors: The Two-Year Reversal

An error in ending inventory distorts two years of income statement, then corrects itself. Cost of goods sold equals beginning inventory plus purchases less ending inventory. An overstated ending inventory therefore understates cost of goods sold and overstates net income by the same amount. The next year, that overstated ending inventory becomes the beginning inventory, which reverses the effect.

Take a $6,000 overstatement of ending inventory in Year 1. Year 1 cost of goods sold is $6,000 too low and net income $6,000 too high. In Year 2, cost of goods sold is $6,000 too high and net income $6,000 too low. Across the two years, total net income is correct and the balance sheet is correct at the end of Year 2. However, each year income statement is wrong alone. If the error surfaces after the books close, the correction is a prior period adjustment under ASC 250.

CPA Inventory Notes: Exam Traps to Avoid

Finally, five traps repeat on FAR inventory questions. First, applying replacement cost to a FIFO item: since ASU 2015-11, replacement cost matters only for LIFO and retail inventory. Second, writing inventory back up after a recovery: US GAAP forbids it. Third, forgetting the ceiling and floor: market is replacement cost only when it sits between them. Fourth, treating a LIFO liquidation gain as operating improvement: it is a one time dip into old layers. Fifth, putting consigned goods or FOB destination goods in transit in the wrong inventory is a common error. Ask who owns the goods at the count date.

One-Page Revision Box: CPA Inventory Notes

Cost flow: FIFO sells oldest costs first, LIFO newest, weighted average $12.80 per unit. Rising prices: LIFO gives the highest cost of goods sold and lowest profit; FIFO the reverse.

Measurement: FIFO and average cost use lower of cost or NRV; LIFO and retail use lower of cost or market. NRV is selling price less completion, disposal, and transportation costs. Market is replacement cost, capped by the NRV ceiling and floored at NRV less normal profit.

Write-downs: Example 2 totals $3,500 ($2,000 LCNRV plus $1,500 LCM). No reversal under US GAAP.

Dollar-value LIFO: deflate to base year dollars and add a layer at the current index. Remove newest layers first: $122,000 ending inventory, $10,000 reserve.

LIFO reserve: FIFO less LIFO inventory, $800 in Example 1.

Errors: a $6,000 overstatement lifts Year 1 income $6,000 and cuts Year 2 income $6,000.

Ownership: FOB shipping point goes to the buyer in transit, FOB destination stays with the seller, consignment with the consignor.

Tax: IRC Section 472 conformity rule, Form 970 election, LIFO banned under IFRS.

Finally, redo both worked examples from the facts alone. For the full CPA study collection, return to the CPA notes hub.

Sources

• PocketCPA: Every FAR CPA Exam Topic, All 56 Named in the Blueprint (AICPA Blueprint summary: FAR.II 30 to 40 percent, inventory topics FAR.II.C under ASC 330, Application and Analysis)
• Becker: FAR CPA Exam Complete Guide (FAR content areas and weights, 4 hour exam, 50 multiple choice questions, 7 task based simulations)
• Business-Software.com: Lower of Cost or Net Realizable Value Guide (ASU 2015-11, July 2015, effective for fiscal years beginning after December 15, 2016; NRV definition; LCM retained for LIFO and retail method; no reversal under US GAAP)
• LegalClarity: Is LIFO Allowed Under GAAP? (ASC 330-10-30-9 cost flow methods; LIFO reserve disclosure; IRC Section 472 conformity rule; Form 970; LIFO liquidation; IAS 2 ban)
• AccountingTools: Dollar-Value LIFO Method (layer mechanics: deflate to base year dollars, price the layer at the current index, liquidate newest layers first)
• UQ Consulting: Inventory Valuation, IAS 2 vs ASC 330 Deep Dive (ASC 330-10-35 write-down as a new cost basis; IAS 2 reversal contrast)