2025 Guide: When to Use Last In, First Out (LIFO) for Inventory Accounting and Tax Savings

Last In, First Out (LIFO) is an inventory accounting technique where the most recently acquired items are recorded as sold first. While LIFO is prohibited under International Financial Reporting Standards (IFRS) used by the European Union, Japan, Russia, Canada, India, and many other countries, it remains permitted in the United States under Generally Accepted Accounting Principles (GAAP).

Alternatives to LIFO include First In, First Out (FIFO), which records the oldest inventory as sold first, and the Average Cost method, which calculates cost of goods sold (COGS) based on the weighted average cost of all inventory during the period.

Key Insights

• LIFO records the newest inventory as sold first, which can be beneficial during periods of rising prices.
• The U.S. uniquely permits LIFO under GAAP, while most other countries follow IFRS that disallow it.
• Industries facing increasing costs, such as retail and automotive, often benefit from LIFO accounting.

When prices increase, companies using LIFO can lower taxable income by matching recent higher costs against revenues, resulting in tax savings. Businesses with substantial inventory—such as retailers and car dealerships—commonly adopt LIFO.

How LIFO Functions

Under LIFO, a company assumes the last items added to inventory are sold first. This contrasts with FIFO, where the oldest inventory is considered sold first. Although actual sales might not follow this pattern, the assumption is used for accounting purposes. If inventory costs remained constant, the choice between LIFO and FIFO wouldn’t impact financials. However, as prices typically rise over time, the method chosen significantly affects reported costs and profits.

Who Benefits Most from LIFO Accounting?

Businesses selling products with rising prices benefit from LIFO because it aligns revenue with the latest costs and reduces taxable income. This leads to lower tax liabilities and fewer inventory write-downs. Supermarkets, pharmacies, convenience stores, and fuel or tobacco retailers often use LIFO due to inflation in their product costs.

Critiques of LIFO

Critics argue LIFO can distort inventory values on balance sheets during inflationary periods and provides companies with an unfair tax advantage by lowering net income and taxes owed.

LIFO in Action: A Coffee Mug Seller Example

Consider One Cup, Inc., an online coffee mug retailer. When mug prices rise from 2016 to 2019, LIFO results in a higher COGS by accounting for the most recent purchases first, reducing taxable income. Conversely, during falling prices, LIFO results in lower COGS compared to FIFO.

COGS Comparison Under Rising and Falling Prices

During inflation, LIFO’s higher COGS better reflects the current replacement costs of inventory, adhering to accrual accounting’s matching principle. FIFO, by selling older inventory first, may understate current costs in such periods.

Tax Advantages of LIFO During Inflation

Higher COGS under LIFO lowers net profits and reduces tax bills, a point of contention among critics who see this as an unfair tax break. Proponents counter that tax savings are often reinvested and that FIFO-based taxes during inflation can be misleadingly high.

Reduced Inventory Write-Downs with LIFO

LIFO also minimizes inventory write-downs during inflation. Since inventory is valued at older, lower costs on the balance sheet, there’s less risk of inventory being recorded above market value. Write-downs, which decrease profitability and asset values, are less frequent under LIFO, preserving financial ratios and avoiding irreversible accounting impacts.

Conclusion: Why LIFO Makes Sense During Rising Prices

For companies facing escalating inventory costs, LIFO offers significant advantages by reducing tax liabilities and better matching revenues with current expenses. While not permitted globally, LIFO remains a valuable accounting method in the U.S. for managing financial performance amid inflation.

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