LIFO vs FIFO: Inventory Accounting and Its Effects

Key Takeaways

• FIFO assumes the oldest costs leave inventory first, so cost of goods sold reflects older prices and ending inventory reflects the most recent ones.
• LIFO assumes the newest costs leave first, so cost of goods sold reflects current prices while ending inventory can sit at stale, decades-old costs.
• When prices rise, LIFO reports higher cost of goods sold, lower gross profit, and lower taxable income than FIFO; when prices fall, the effect reverses.
• The LIFO reserve is the dollar gap between LIFO and FIFO inventory, and analysts add it back to compare a LIFO filer against FIFO peers.

What It Is

FIFO (First In, First Out) assumes the first units purchased are the first ones sold. The cost attached to the earliest inventory is expensed first, and whatever remains in ending inventory carries the most recent purchase costs.

LIFO (Last In, First Out) assumes the most recently purchased units are sold first. Current costs flow into cost of goods sold, while ending inventory holds the oldest cost layers, sometimes many years out of date.

Neither method has to match the physical flow of goods. A grocer can rotate stock so old milk sells first yet still elect LIFO for accounting. The choice is a cost-flow assumption, not a warehouse rule.

The Intuition

Think of inventory as stacked cost layers. FIFO pulls from the bottom, so the income statement expenses old prices and the balance sheet shows new ones. LIFO pulls from the top, so the income statement expenses new prices and the balance sheet keeps the old layers buried underneath.

Because the same total dollars of purchases are split between the income statement and the balance sheet, whatever LIFO adds to cost of goods sold it removes from ending inventory, and vice versa. In an inflationary world that split is the whole story: LIFO shifts recent, higher costs into expense, shrinking profit and the tax bill, while FIFO leaves those higher costs on the balance sheet.

How It Works

Under US GAAP, a company may choose FIFO, LIFO, or weighted average cost. US tax law adds a catch called the LIFO conformity rule: a firm that uses LIFO for its tax return must also use it in its financial statements.

IFRS, used across most of the world, bans LIFO outright under IAS 2, which is why cross-border comparisons require care. That is also why the LIFO reserve exists. The reserve is the difference between what inventory would be worth under FIFO and its reported LIFO value. Filers disclose it, and analysts use it to restate a LIFO company onto a FIFO basis before comparing margins or multiples.

Worked Example

A retailer buys the same product three times in a year as the price climbs:

• Beginning inventory: 100 units at $10 = $1,000
• Purchase 1: 100 units at $12 = $1,200
• Purchase 2: 100 units at $14 = $1,400

Total available: 300 units costing $3,600. During the year it sells 200 units at $20 each, for revenue of $4,000.

FIFO expenses the oldest layers first. Cost of goods sold = 100 at $10 plus 100 at $12 = $1,000 + $1,200 = $2,200. Ending inventory = the remaining 100 units at $14 = $1,400. Gross profit = $4,000 − $2,200 = $1,800.

LIFO expenses the newest layers first. Cost of goods sold = 100 at $14 plus 100 at $12 = $1,400 + $1,200 = $2,600. Ending inventory = the oldest 100 units at $10 = $1,000. Gross profit = $4,000 − $2,600 = $1,400.

The LIFO reserve here is FIFO inventory minus LIFO inventory = $1,400 − $1,000 = $400, exactly the gap between the two cost-of-goods-sold figures. LIFO reports $400 less pretax profit, so at a 25% tax rate it defers about $100 of tax. Same units, same cash spent, two very different income statements.

Common Mistakes

1. Assuming cost flow equals physical flow. LIFO does not mean old stock rots on the shelf. It is purely an accounting assumption.
2. Comparing a LIFO filer directly with a FIFO peer. Their margins and inventory are not on the same basis. Add the LIFO reserve back before comparing.
3. Forgetting the direction of prices. LIFO only lowers profit and taxes when costs are rising. In deflation the relationship flips.
4. Ignoring LIFO liquidation. If a LIFO firm sells more than it buys, it dips into old low-cost layers, spiking reported profit and taxes in a way that is not repeatable.
5. Overlooking the tax conformity rule. A US firm cannot quietly use LIFO for taxes and FIFO for its published results.

Frequently Asked Questions

Q: What is the core difference in lifo vs fifo? FIFO expenses the oldest inventory costs first and leaves the newest costs on the balance sheet. LIFO expenses the newest costs first and leaves the oldest costs in ending inventory. The physical goods can be identical; only the cost-flow assumption differs.

Q: Does lifo vs fifo change how much cash a company actually has? Not directly, but it changes taxable income. When prices rise, LIFO reports lower profit, which reduces the current tax bill and therefore preserves cash. That tax effect is the main practical reason a company chooses LIFO.

Q: Is LIFO allowed everywhere? No. US GAAP permits LIFO, but IFRS prohibits it under IAS 2. Companies reporting under IFRS must use FIFO or weighted average cost, which is why LIFO is largely a US phenomenon.

Q: What is the LIFO reserve and why does it matter? The LIFO reserve is the dollar difference between inventory valued under LIFO and what it would be under FIFO. Adding it back lets an analyst restate a LIFO company onto a FIFO basis so its inventory, margins, and multiples can be compared fairly.

Q: Which method makes profit look higher when costs are rising? FIFO. Because it pushes older, cheaper costs into cost of goods sold, FIFO reports a smaller expense and a larger gross profit than LIFO during inflation, at the cost of a higher tax bill.

Sources

1. Investopedia. "Last In, First Out (LIFO)." https://www.investopedia.com/terms/l/lifo.asp
2. Investopedia. "First In, First Out (FIFO)." https://www.investopedia.com/terms/f/fifo.asp
3. Investopedia. "LIFO Reserve." https://www.investopedia.com/terms/l/lifo-reserve.asp
4. IFRS Foundation. "IAS 2 Inventories." https://www.ifrs.org/issued-standards/list-of-standards/ias-2-inventories/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.