For businesses that carry inventory, the choice of inventory accounting method—FIFO, LIFO, or weighted average—determines how cost of goods sold and ending inventory are calculated. In stable price environments, the methods produce similar results. In inflationary environments, they diverge significantly.
FIFO (First In, First Out)
FIFO assumes that the oldest inventory items are sold first. In an inflationary environment, FIFO results in lower cost of goods sold (because older, cheaper inventory is being expensed) and higher gross profit. This produces better-looking financial statements but a higher tax bill.
LIFO (Last In, First Out)
LIFO assumes that the newest inventory is sold first. In inflation, LIFO results in higher cost of goods sold and lower gross profit—meaning lower taxes. The downside is that LIFO is not permitted under International Financial Reporting Standards (IFRS), creating complexity for businesses with international operations or investors.
Key Takeaways
- FIFO shows higher profit in inflationary periods; LIFO reduces taxes in inflationary periods.
- LIFO is not permitted under IFRS—relevant if you have international operations or investors.
- Once you choose a method, changing it requires IRS approval and can create a tax impact in the year of change.
