FIFO vs LIFO: How Inventory Costs Change Profit and Taxes

FIFO vs LIFO comes down to which costs hit the income statement first. FIFO (first-in, first-out) expenses the oldest inventory costs first; LIFO (last-in, first-out) expenses the newest. When prices rise, FIFO generally shows lower cost of goods sold (COGS), higher profit, and higher ending inventory, while LIFO generally shows higher COGS and can lower taxable income. These comparisons depend on the assumptions explained below. U.S. GAAP allows both, but IFRS prohibits LIFO.

When prices fall, the results flip. The example below holds sales constant so you can see exactly how the cost assumption changes profit and taxes.

Prefer to learn by watching? Professor Farhat works through FIFO vs LIFO practice questions in a 17-minute video. As you watch, find the costs still on the balance sheet before you calculate gross profit. Watch Professor Farhat’s explanation on YouTube.

What is the difference between FIFO and LIFO?

FIFO and LIFO are cost flow assumptions. They decide which purchase costs move to cost of goods sold, not which physical boxes leave the shelf. A store can physically sell its oldest lamps first and still use LIFO for its accounting. Weighted average sits in between. Under a periodic system, it applies one average cost to every unit sold.

Comparison assumptions: The price comparisons below assume the same purchases, sales, and other expenses under both methods, a consistent purchase-price trend, inventory remaining on hand, and no LIFO liquidation or inventory write-downs. The tax comparison uses the simplified assumptions in the worked example: the same method for books and tax, a 25% tax rate on positive pretax income, and tax expense equal to current tax payable.

When prices fall, every ‘higher’ and ‘lower’ in the price rows flips.

Start with what the retailer paid and sold

Consider Harbor Field Supply, a hypothetical U.S. retailer. It begins the month with no inventory, buys 80 lamps at $15 each, then buys 80 more at $19 each. After both deliveries, it sells 100 lamps at $32 apiece. Total sales are $3,200. The store has 60 lamps left and $2,720 of purchase cost to allocate. Operating expenses are $620 under every method.

Assume the store applies one method consistently for books and tax, its only tax is a simplified 25% of positive pretax income, and tax expense equals current tax payable. These assumptions let you isolate the inventory method. For a comparison in which a sale occurs between deliveries, work through periodic vs perpetual inventory costing.

FIFO vs LIFO on the income statement and balance sheet

FIFO assigns the first 80 costs at $15 and the next 20 at $19 to sales. Expense is $1,580. LIFO assigns the most recent 80 costs at $19 and then 20 at $15, giving expense of $1,820. Weighted average divides $2,720 by 160 lamps to get $17 per unit. Multiplying that by 100 gives the $1,700 expense in the middle column.

Read down the FIFO column. Subtract $1,580 from sales to find $1,620 of gross profit. Deduct $620 of operating expenses, then apply 25% to the $1,000 pretax profit. The result is $750 of net income. To check ending inventory independently, multiply the 60 lamps remaining by their $19 unit cost to get $1,140.

Now read across the ending inventory and COGS rows. LIFO carries $240 less inventory and records $240 more expense. The tax difference is $60 (25% × $240), so the difference in net income is $180. The customers bought the same 100 lamps, and the supplier charged the same $2,720 under both methods.

What are the journal entries under FIFO and LIFO?

Assume Harbor uses a perpetual inventory system and buys and sells on account. Because both purchases arrived before the sale, a perpetual system gives the same numbers as the table above.

The only entry that changes is the cost entry. Everything else, including what Harbor owes its supplier, stays the same.

Why would a company choose FIFO or LIFO?

Recent costs in inventory. FIFO leaves the later invoice costs in ending inventory. When prices rise, this produces a higher inventory balance and higher working capital (current assets minus current liabilities). In Harbor’s case, FIFO inventory is $240 higher, but FIFO also creates $60 more income tax to pay, so working capital ends up $180 higher. Recent invoice costs can be informative, although they can still differ from today’s replacement price.

Recent costs against sales. LIFO assigns more of the newer costs to expense. In the example, FIFO’s reported margin includes the advantage of buying 80 lamps before the supplier raised its price. A manager estimating the margin on the next delivery should take that price increase into account.

Current tax and cash. Under the example’s assumptions, Harbor owes $60 less current tax with LIFO. When it pays the tax, it retains $60 more cash. The supplier payments and customer receipts are identical. Lower current tax is often a deferral rather than a permanent saving. If inventory levels fall or the company leaves LIFO, the postponed tax can come due. Its size depends on prices, quantities carried, and the taxpayer’s circumstances.

The U.S. LIFO conformity rule in Internal Revenue Code section 472 is the catch. A business that elects LIFO for tax purposes (the election is made on IRS Form 970) generally must also use LIFO when it reports income for those goods to owners and creditors. In plain terms, the company generally cannot pay tax on lower LIFO profits while reporting higher FIFO profits as its main income figure. A company may present supplementary non-LIFO information subject to the applicable rules. U.S. GAAP (FASB ASC 330, Inventory) allows FIFO, LIFO, and average cost. IFRS does not allow LIFO. Under International Accounting Standard 2 (IAS 2), companies use FIFO or weighted average cost for items that are ordinarily interchangeable, meaning one unit can substitute for another, and specific identification for items that are not. That difference matters when you compare a U.S. company with one reporting under IFRS, and it is a favorite CPA FAR exam point.

What happens when prices fall?

Reverse the prices in Harbor’s example. Buy the first 80 lamps at $19 and the next 80 at $15. FIFO now assigns $1,820 to expense, while LIFO assigns $1,580. The method names describe the order of the costs. The direction of the price change determines which cost is higher.

How do you compare a LIFO company with a FIFO company?

Read a company’s inventory note before comparing margins. The gap between FIFO inventory and reported LIFO inventory is called the LIFO reserve. For example, if a note says FIFO inventory would exceed reported LIFO inventory by $240, the LIFO reserve is $240. Add it to the LIFO balance to compare the two ending balances. The amount is a balance-sheet difference at one date. It does not automatically equal the current year’s profit difference if a difference also existed at the start of the year. The current year’s pretax profit difference equals the change in the LIFO reserve. If the reserve grows from $100 at the start of the year to $240 at the end, FIFO pretax income for the year is $140 higher than LIFO pretax income. The same change converts cost of goods sold. FIFO COGS equals LIFO COGS minus the increase in the reserve, so here FIFO COGS is $140 lower. For more practice, work through the LIFO reserve lesson in the Intermediate Accounting course.

Can a company switch from LIFO to FIFO?

Yes, but it is a change in accounting principle under FASB ASC 250. The company must show the new method is preferable, meaning it better reflects the company’s results, not just that it produces higher earnings. A switch away from LIFO is normally applied retrospectively, so prior years are restated. A switch to LIFO is usually applied prospectively, because companies rarely have the records to rebuild old LIFO layers. A change away from LIFO can also bring previously deferred taxable income into taxable earnings. A company with lean inventory or little movement in unit costs may get less benefit from maintaining LIFO records. For a real example, PVH’s inventory policy note filed with the SEC explains that in 2011 it moved its U.S. wholesale inventory from LIFO to FIFO and its U.S. retail inventory to weighted average cost. Costs had been falling for several years, so its LIFO inventory already reflected current cost and the change had no effect on its reported amounts.

What is a LIFO liquidation?

A LIFO liquidation occurs when inventory levels decline enough to draw down older LIFO cost layers. In a simple unit-based example, this happens when the company sells more units than it buys. Those older costs flow into COGS. When they are lower than current purchase costs, liquidation reduces COGS and increases profit relative to replacing the units at current costs, and some previously deferred tax may become payable. Older layers are not necessarily cheaper; the effect depends on their costs.

Here is how it looks for Harbor. After the first month, LIFO leaves 60 lamps on the books at $15 each, or $900. In month two, Harbor buys 40 lamps at $21 each ($840). The new lamps arrive before any sales, and Harbor then sells 70.

LIFO expenses the 40 new lamps first ($840), then 30 of the old $15 lamps ($450). COGS is $1,290, and 30 lamps at $15, or $450, stay in inventory.

If Harbor had bought 70 lamps at $21 instead, COGS would have been $1,470. Dipping into the old layer cut COGS by $180 (30 lamps × $6) and, at the 25% rate, added $45 of current tax. That bump in profit comes from shrinking inventory, not from selling better, so analysts and exam questions often ask you to spot it.

See the LIFO liquidation lesson in the Intermediate Accounting course for more practice.

Key takeaways

• FIFO expenses the oldest purchase costs first. LIFO expenses the newest purchase costs first.
• Under the comparison assumptions above, rising prices produce higher ending inventory, higher profit, and higher current tax under FIFO than under LIFO. When prices fall, the results flip.
• Sales, units sold, and supplier payments are identical under both methods. In Harbor’s example, LIFO records $240 more COGS, $60 less tax, and $180 less net income.
• U.S. GAAP allows LIFO, but IFRS does not. A company that elects LIFO for U.S. taxes generally must use LIFO in its financial reports too.
• The LIFO reserve is FIFO inventory minus LIFO inventory. The change in the reserve during the year equals the pretax income difference.

Common FIFO vs LIFO exam traps

• Confusing physical flow with cost flow. FIFO and LIFO assign costs. They do not have to match which boxes actually leave the shelf.
• Flipping the direction when prices fall. The method name tells you the order of costs. The price trend tells you which method shows the higher profit.
• Assuming LIFO gives the same answer under periodic and perpetual systems. FIFO always does. LIFO and average cost can differ when sales happen between purchases. Practice with periodic vs perpetual inventory costing.
• Treating the LIFO reserve balance as this year’s income difference. Use the change in the reserve during the year.
• Forgetting that IFRS bans LIFO. If a question says the company reports under IFRS, LIFO is off the table.
• Using the wrong write-down test. Under U.S. GAAP, FIFO and average cost inventory is measured at the lower of cost and net realizable value (NRV), meaning estimated selling price minus the costs to complete and sell. LIFO and retail method inventory still uses lower of cost or market. Review lower of cost or net realizable value.
• Thinking LIFO changes what the supplier is paid. Only the tax payment changes cash. In Harbor’s case, that is $60.

Practice questions

1. Which line stays at $3,200 under every method?

Answer: Sales revenue. Harbor sold 100 lamps at $32 each. The inventory method only decides how purchase costs split between expense (COGS) and an asset (ending inventory).

2. What does the $240 pretax difference mean for cash?

Answer: Only the $60 difference in current taxes changes cash when tax is paid under these assumptions. The $240 itself is the difference in the costs recognized as expense.

3. If every unit costs $17, which method gives higher gross profit?

Answer: Both give $1,500. Either method expenses 100 × $17, or $1,700, against $3,200 of sales. Without a difference in unit costs, changing their order has no effect here.

Frequently asked questions

Does a higher FIFO profit mean the retailer sold more goods?

No. Unit sales and selling prices can be identical. When costs rise, assigning earlier, cheaper purchases to expense can increase the current period’s reported profit.

Is weighted-average profit always exactly halfway between FIFO and LIFO?

Not always. Harbor bought two equal lots of 80 lamps, so the $17 average cost sits exactly halfway between $15 and $19, and the $1,700 COGS lands exactly halfway between $1,580 and $1,820. When the lots are different sizes, the average cost leans toward the price of the bigger lot, so the result is usually not exactly halfway. See how unequal purchases affect the four inventory cost flow methods.

Can a company choose the more favorable method every quarter?

Companies apply their inventory policies consistently. Changing a policy requires a justified accounting change and appropriate disclosures. A favorable earnings result by itself does not establish preferability.

Is LIFO allowed under IFRS?

No. IAS 2 does not permit LIFO. Companies reporting under IFRS use FIFO, weighted average cost, or specific identification for items that are not interchangeable. LIFO is allowed under U.S. GAAP, which is why it still shows up on U.S. exams like CPA FAR.

Which is better, FIFO or LIFO?

Neither is better in every situation. FIFO keeps ending inventory closer to recent costs and is permitted under both U.S. GAAP and IFRS. LIFO matches newer costs against sales and can lower U.S. income taxes when prices rise. A company that elects LIFO for U.S. tax purposes generally must also use LIFO when reporting income for those goods to owners and creditors. LIFO cannot be used under IFRS.

What is the LIFO reserve?

The LIFO reserve is the difference between inventory measured under FIFO (or another non-LIFO method) and inventory reported under LIFO. In the Harbor example it is $1,140 minus $900, or $240. The change in the reserve during a year equals the difference in pretax income between the two methods.

Do FIFO and LIFO give the same answer under periodic and perpetual inventory?

FIFO always does, because the oldest costs leave first no matter when you record them. LIFO and average cost can give different answers when sales happen between purchases. Harbor made both purchases before any sale, so its numbers are the same under either system.

About the author

Mansour Farhat, CPA, CIA, DBA, teaches accounting and CPA, CMA, and EA exam topics through Farhat Lectures video lessons and practice questions.