This method assumes the most recently purchased units are the ones sold first, which is the opposite of how stock usually moves physically and is chosen for what it does to reported results rather than for realism.
It comes with obligations that outlast the decision. The layers laid down in early years stay on the balance sheet indefinitely, so the records behind them remain live supporting documents rather than archives.
This covers how the method works, a worked example, what happens to reported results when prices rise, the reserve that reconciles it to the alternative, the conformity requirement, and the risk when old layers are finally sold.
LIFO (Last In, First Out) assumes the most recently purchased inventory is sold first. In periods of rising prices, LIFO produces higher COGS and lower taxable income, giving businesses a tax deferral benefit. However, LIFO is not permitted under IFRS and comes with compliance complexity.
How LIFO Works
When a sale occurs, COGS is drawn from the newest cost layer first. Older, often cheaper inventory layers accumulate on the balance sheet as ending inventory.
The layers laid down in early years stay on the balance sheet indefinitely, which means the purchase records behind them are live supporting documents rather than archives. A change of accounting system has to carry them across rather than start fresh.
Anu Gupta, CA, EA, B.Tech · LinkedInLIFO Example with Three Purchase Layers
| Purchase Date / Layer | Units x Cost |
|---|---|
| January: Layer 1 | 100 units @ $10 = $1,000 |
| March: Layer 2 | 150 units @ $12 = $1,800 |
| June: Layer 3 | 200 units @ $14 = $2,800 |
If you sell 200 units under LIFO:
| Units Sold | LIFO Cost |
|---|---|
| First 200 from Layer 3 (most recent) | 200 x $14 = $2,800 |
| COGS for 200 units | $2,800 |
| Ending Inventory (250 units) | 100 @ $10 + 150 @ $12 = $2,800 |
| vs FIFO COGS for same 200 units | $2,200 (LIFO produces $600 more COGS) |
Tax Benefits of LIFO in Rising Prices
Higher COGS under LIFO reduces gross profit, which reduces taxable income. This is a deferral, not a permanent savings, if prices ever fall or inventory is liquidated, the deferred tax comes due.
LIFO Reserve
The LIFO Reserve is the cumulative difference between LIFO and FIFO inventory values. US GAAP requires disclosure of the LIFO Reserve in the notes to financial statements. Analysts add the LIFO Reserve back to inventory to compare companies using different methods.
LIFO Reserve = FIFO Inventory Value - LIFO Inventory Value
LIFO Conformity Rule
Under IRS rules, if a company uses LIFO for tax purposes, it must also use LIFO for financial reporting (GAAP). It cannot use FIFO for the income statement and LIFO only for tax.
LIFO Liquidation Risk
If inventory falls below the oldest LIFO layers (because you sell more than you buy), you are forced to recognise the old, cheaper layer costs in COGS, reducing COGS, increasing gross profit, and generating an unexpected tax bill. This is called a LIFO liquidation.
Who Uses LIFO
| Industry | Why LIFO Makes Sense |
|---|---|
| Oil and gas | Large commodity inventory, significant price inflation in costs |
| Retail (large chains) | High-volume commodity-like goods where LIFO reserve provides meaningful tax deferral |
| Wholesalers | Large inventory with inflationary cost pressure |
LIFO is Not Permitted Under IFRS
IFRS explicitly prohibits LIFO. Companies reporting under IFRS (most non-US listed companies) must use FIFO or weighted average. US companies with international subsidiaries or planning a cross-border listing should weigh this carefully.
Book a free consultation and we will get the numbers straight.
Frequently Asked Questions
Why would anyone choose LIFO given its complexity?
The primary reason is US tax deferral. In an inflationary environment with growing inventory levels, the cumulative LIFO Reserve can represent millions in deferred taxes. The tax benefit often outweighs the complexity cost for larger businesses.
Can a small business use LIFO?
Yes, but the compliance burden (IRS Form 970 to elect LIFO, LIFO Reserve calculations, mandatory GAAP disclosure) often outweighs the benefit for businesses with less than $5M in inventory.
What happens to the LIFO Reserve if a company switches to FIFO?
The entire LIFO Reserve is recognised as income in the year of the method change, triggering a large one-time tax bill. IRS Form 3115 is required to change inventory methods.
What does this method demand of the bookkeeping that the alternative does not?
Records that stretch back further than you expect. The layers laid down in early years stay on the balance sheet indefinitely, so the supporting detail for a cost established years ago still has to be produced if anyone asks. That means the purchase records behind the oldest layers are not archives, they are live supporting documents, and a change of accounting system has to carry them across rather than start fresh.
How does the choice affect a sale of the business?
It affects what a buyer sees and what they will argue about. Reported profit and the carrying value of stock both differ under the two methods, so a buyer working from a multiple of earnings is working from a figure the method shaped. Expect the difference between the two to be a line in any diligence exercise, and expect to be asked to show the position both ways.
Written by
Anu Gupta, CA, EA, B.Tech
Anu works with US businesses on tax and entity questions at Profitjets, from choosing a structure to the filings that follow it. She writes about the decisions owners make once and then live with for years. Connect on LinkedIn
Free consultation
Want Books You Can Rely On?
Book a free consultation and we will get the numbers straight.