I have seen many CFA Level 1 candidates have a hard time figuring out the relationship between COGS (Cost of Goods Sold) and the change in LIFO (Last in, First out) Reserve.

If you’ve been thinking about this question, then you have touched on one of the most frequently tested points on the CFA Level 1 exam.

I know it is hard to convert from Inventory and LIFO Reserve to COGS and the change in LIFO Reserve because you have to figure out how both of those equations are derived (at least once.)

Example Change in LIFO Reserve Equation

I’m assuming you already know when LIFO is converted to FIFO, required by IFRS, that the company’s inventory balance increases by the amount equal to LIFO Reserve, given that the prices go up.

The equation can look like this:

LIFO Reserve = FIFO – LIFO …………(1)

Equation (1) can also be derived as:

△LIFO Reserve = △Inventory (FIFO) – △Inventory (LIFO) ……………..(1)a

Because the T account bridges Cost of Good Sold (COGS) from the income statement and inventory from the balance sheet as follows:

Beginning Inventory+Purchase – COGS = Ending Inventory

Therefore, by moving beginning inventory and purchase accounts to the right side of equation:

COGS = Beginning Inventory – Ending Inventory + Purchase ……………(2)

Now the “fun” part begins.

Under FIFO

COGS(FIFO) = Beg. Inventory (FIFO) – End. Inventory (FIFO) + Purchase = – △Inventory (FIFO) + Purchase

Under LIFO

COGS(LIFO) = Beg. Inventory (LIFO) – End. Inventory (LIFO) + Purchase =  - △Inventory (LIFO) + Purchase

So, COGS(FIFO) – COGS(LIFO) = △I(LIFO) – △I(FIFO) …………..(3)

Combine equation (1)a and equation (3), now we can get the relation between COGS and LIFO:

COGS（FIFO）- COGS（LIFO) = – △LIFO Reserve ……………..(4)

Put both equation (1)a and (4) into your cheat sheet and try to derive equation (4) from (1)a by yourself. This process of thinking will definitely help you memorize the formula by truly understanding the built-in rationale.

Tracy