Inventory Accounting: FIFO vs LIFO

FIFO (first in, first out) assumes the oldest inventory is sold first; LIFO (last in, first out) assumes the newest is sold first. When costs are rising, FIFO reports higher profit and higher inventory, while LIFO reports lower profit, lower tax and a cheaper-looking balance sheet. The goods need not move in that order; the choice is purely an accounting convention.

Inventory sits quietly on the balance sheet of almost every retailer, manufacturer and distributor. How a company values it decides how much profit it reports, how much tax it pays, and how healthy its margins look. Two companies selling identical goods can post different profits simply because they count inventory differently.

Where this fits: inventory accounting is part of reading the financial statements well, which supports every one of the Five Criteria. Start with the introduction to financial statements, and this guide pairs naturally with the cash conversion cycle, which measures how quickly inventory turns back into cash.

What Inventory Costing Actually Decides

When a company sells a product, it moves the cost of that product from inventory on the balance sheet to cost of goods sold on the income statement. The question is: which cost?

A shop that bought identical widgets over the year at different prices has to decide which batch’s cost to record when it makes a sale. The physical widget is the same. The cost attached to it is a choice.

That choice splits total costs between two places:

• The portion sent to cost of goods sold, which reduces this year’s profit.
• The portion left in ending inventory, which stays on the balance sheet.

Because the two must add up to the same total, anything that lowers cost of goods sold raises inventory, and vice versa. The method simply decides how the pie is cut.

FIFO: First In, First Out

Under FIFO, the first units bought are the first charged to cost of goods sold. The costs still sitting in inventory are therefore the most recent ones.

This usually matches how perishable goods physically move: a grocer sells the oldest milk first. But FIFO is an accounting rule, not a stocking rule. A company can use FIFO costing while shipping goods in any order.

The effect when costs rise: older, cheaper costs flow into cost of goods sold, so gross profit looks higher. Ending inventory holds the newest, dearest costs, so the balance sheet value is close to current replacement cost.

FIFO therefore gives a realistic balance sheet and a slightly flattering income statement in an inflationary period. The higher reported profit also means a higher tax bill.

LIFO: Last In, First Out

Under LIFO, the most recent units bought are the first charged to cost of goods sold. The costs left in inventory are the oldest ones.

This rarely matches physical flow. A coal merchant does not dig to the bottom of the pile. LIFO is chosen for its accounting effect, not because goods move that way.

The effect when costs rise: newer, higher costs flow into cost of goods sold, so cost of goods sold is larger and reported profit is lower. Ending inventory holds old, cheap costs, so the balance sheet understates what the stock is really worth.

Lower reported profit means a lower tax bill. In the United States, companies must use the same method for tax and for reporting (the “LIFO conformity rule”), so firms that adopt LIFO accept lower reported earnings in exchange for a real cash tax saving.

LIFO is permitted under US GAAP but banned under IFRS, which most of the world uses. That single fact makes cross-border comparison a trap for the unwary.

A Hypothetical Side-by-Side

Imagine a company, Company A, a small distributor that sells one product. Over the year it makes three purchases and then sells 250 units at £20 each, for revenue of £5,000. This is a simplified illustration, not a real company.

Purchase	Units	Cost each	Total cost
January	100	£10	£1,000
June	100	£12	£1,200
November	100	£14	£1,400

Costs are rising through the year. The company sells 250 of its 300 units, leaving 50 in ending inventory. Here is how the two methods split the costs.

Line	FIFO	LIFO
Revenue	£5,000	£5,000
Cost of goods sold	£2,800	£3,100
Gross profit	£2,200	£1,900
Ending inventory (50 units)	£700	£500

Under FIFO, the 250 units sold take the January, June and half the November costs (£1,000 + £1,200 + £600 = £2,800), leaving the newest 50 units at £14 each in inventory. Under LIFO, the 250 units sold take the November, June and half the January costs (£1,400 + £1,200 + £500 = £3,100), leaving the oldest 50 units at £10 each in inventory.

Same sales, same purchases, same business. FIFO shows £300 more gross profit and £200 more inventory. LIFO shows less profit, a lower tax bill, and a balance sheet that undervalues the stock. Nothing about the company changed except the label on the costing method.

Why the Difference Matters to an Investor

Margins and quality of earnings

A sudden jump in reported margins can come from the inventory method rather than the business. When input costs fall, FIFO can push old, expensive costs through cost of goods sold and depress margins; when costs rise, it flatters them. Knowing the method keeps you from mistaking an accounting swing for a real improvement. This is a core theme of quality of earnings and sits behind our work on gross margin.

The balance sheet can be badly understated

A company that has used LIFO for decades may carry inventory at costs from many years ago. Its inventory line can be a small fraction of what the goods would fetch today. That matters if you value the business on its assets, and it is exactly why IFRS banned the method.

Comparability across borders

A US manufacturer on LIFO and a European one on FIFO are not directly comparable. Before you line them up, convert the LIFO reporter to a FIFO basis using the disclosed LIFO reserve.

The LIFO Reserve: Your Adjustment Tool

US companies that use LIFO must disclose the LIFO reserve in the inventory note, the subject of our guide on reading the notes to the financial statements. The reserve is the gap between LIFO inventory and what it would be under FIFO.

Two quick adjustments let you compare like with like:

• FIFO inventory = LIFO inventory + LIFO reserve. This restates the balance sheet to recent costs.
• A change in the reserve during the year can be added to or subtracted from cost of goods sold to approximate FIFO profit.

If the reserve is large and growing, the company’s reported profit and inventory are being held down meaningfully by LIFO. A shrinking reserve can signal that old, cheap layers are being sold (“LIFO liquidation”), which temporarily inflates profit in a way that will not repeat.

Weighted Average: The Quiet Third Option

Both FIFO and LIFO have a middle sibling: weighted-average cost. It pools all purchase costs and charges the average to each unit sold. It smooths the swings of FIFO and LIFO and is common for commodities and bulk goods. IFRS allows FIFO and weighted average, but not LIFO.

Method	Cost to COGS when prices rise	Inventory on balance sheet	Allowed under IFRS?
FIFO	Oldest (lower)	Recent cost (realistic)	Yes
LIFO	Newest (higher)	Old cost (understated)	No
Weighted average	Blended	Blended	Yes

How This Fits the Five Criteria

Inventory accounting does not change whether a business is good. It changes how the numbers look, so your job is to see through it to the real economics.

• Criterion 1 (a great business): adjust margins and return on invested capital to a consistent basis before judging quality. LIFO can flatter return on capital by understating the inventory in the denominator.
• Criterion 4 (a sound balance sheet): a LIFO balance sheet can hide the true value of current assets. Restate inventory with the reserve before assessing working capital.
• Across the board: remember that free cash flow is unaffected by the labelling choice, except through the real tax difference. Cash is harder to dress up than profit, which is one reason we lean on it.

A business that keeps switching methods, or whose margins move only because of inventory accounting, belongs on the list of red flags to investigate further.

Frequently Asked Questions

Is FIFO or LIFO better for investors?

Neither is better as a business; they describe accounting, not performance. FIFO usually gives a more realistic balance sheet because inventory is valued at recent costs. LIFO can give a more realistic income statement when costs are rising, because cost of goods sold reflects current prices. The key is to know which one a company uses and adjust before you compare.

Why is LIFO banned under IFRS?

The IASB removed LIFO because it can leave very old, unrealistic costs sitting in inventory on the balance sheet, and because it allows companies to manage profit by timing purchases near the year end. IFRS allows only FIFO and weighted-average costing. US GAAP still permits all three.

What is the LIFO reserve?

The LIFO reserve is the difference between inventory valued under LIFO and what it would be worth under FIFO. US companies that use LIFO must disclose it in the notes. Adding the reserve to LIFO inventory gives you a FIFO-equivalent figure so you can compare the company with IFRS reporters.

How does the inventory method affect profit when prices are rising?

Under FIFO the cheaper, older costs flow to cost of goods sold, so gross profit looks higher. Under LIFO the newer, higher costs flow through first, so cost of goods sold is larger and profit is lower. The lower LIFO profit also means a lower tax bill, which is the main reason some US firms choose it.

Does the inventory method change a company’s cash flow?

Only through tax. The accounting split between inventory and cost of goods sold is non-cash. But because LIFO lowers reported (and in the US, taxable) profit when costs rise, it reduces the cash paid in tax. That genuine cash saving is the real economic effect of the choice.

Your Next Step

Pick one company you follow and find the inventory method in the notes. If it uses LIFO, restate its inventory with the LIFO reserve and see how much the balance sheet changes. Then read the cash conversion cycle to measure how fast that inventory becomes cash, and revisit gross margin on a consistent basis. When you are ready to judge the whole business, run it through the Five Criteria Scorecard.

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About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.

The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.