LIFO, last-in, first-out, is an inventory cost-flow assumption: the most recently acquired or produced units are treated as the first ones charged to cost of goods sold, so the units left in ending inventory carry the oldest costs. A cost-flow assumption is a rule for deciding which recorded costs move to expense when goods are sold, and cost of goods sold is the inventory cost charged against revenue in the period of the sale. LIFO decides which dollars move, not which physical units leave the shelf, so in a period of rising costs it charges the newer, higher costs to expense and leaves the older, lower costs sitting in inventory.
How the Code Writes the Assumption
The Internal Revenue Code states the method from the inventory side rather than the sales side. A taxpayer using it treats the goods remaining on hand at the close of the taxable year as, first, those included in the opening inventory of that year in the order of acquisition, to the extent thereof, and second, those acquired during the year. It inventories them at cost. It treats the goods in the opening inventory of the first year on the method as having been acquired at the same time, and determines their cost by the average cost method (26 U.S.C. 472).
Ending inventory is what the statute fixes. Cost of goods sold is what falls out of it once the year’s purchases are added to the opening balance.
Nothing in the mechanics follows a specific unit. Where closing inventory exceeds opening inventory, the regulation costs that increase regardless of identification with specific invoices and regardless of specific cost accounting records (26 CFR 1.472-2). Physical flow and cost flow are separate questions, and the method answers only the second.
How a Taxpayer Elects It
The method is not available by default. A taxpayer may adopt and use it only by filing, with the income tax return for the taxable year as of the close of which the method is first to be used, a statement of election made on Form 970, or in another manner acceptable to the Commissioner, accompanied by an analysis of all inventories as of the beginning and the end of that year and as of the beginning of the prior year (26 CFR 1.472-3).
That form is titled Application To Use LIFO Inventory Method, and it is attached to the return. Its instructions say to file it with the return for the first tax year the method is intended to be used, and that a taxpayer who filed the return without making the election can still make it on an amended return within 12 months of the date the original return was filed, writing “Filed pursuant to section 301.9100-2” at the top of the form. Once adopted, the method is irrevocable unless the IRS allows a change to another method (IRS, Form 970, Rev. November 2020).
The Two Conditions the Election Carries
Two conditions ride along with it.
The first is book conformity. The election applies only if the taxpayer establishes, to the satisfaction of the Secretary, that it used no procedure other than those specified in paragraphs (1) and (3) of subsection (b) in inventorying the goods, to ascertain income, profit or loss for the first taxable year on the method, for the purpose of a report or statement to shareholders, partners or other proprietors, or to beneficiaries, or for credit purposes (26 U.S.C. 472).
Paragraph (2), the instruction to inventory the goods at cost, sits outside that condition. That is why the taxpayer’s use of the lower of LIFO cost or market method to value LIFO inventories for purposes of financial reports and credit statements is not considered at variance with the requirement (26 CFR 1.472-2).
The second is continued use. Once the method has been used, it must be used in all subsequent taxable years, unless the Secretary authorizes a change to a different method, or the Secretary determines that the taxpayer used, in a later year’s report or statement to those same recipients or for credit purposes, some procedure other than the one specified in paragraph (1) of subsection (b), and requires a change to a different method beginning with that year or any year after it (26 U.S.C. 472).
One carve-out inside the conformity rule is worth holding onto, because it is what lets a non-LIFO figure appear at all. Using a method other than LIFO to produce information reported as a supplement to, or an explanation of, the taxpayer’s primary presentation of income, profit or loss in credit statements or financial reports is not considered at variance with the conformity requirement. Information reported on the face of the income statement is not treated as a supplement or an explanation, so the carve-out operates in the notes, in a clearly identified appendix or supplement, and in the other reports the regulation lists (26 CFR 1.472-2).
The LIFO Reserve
The LIFO reserve is the difference between the carrying amount of inventory measured on LIFO and what the same inventory would be carried at under FIFO or another current-cost measure. It exists because the two measures leave different costs sitting in the same units.
On a balance sheet filed under Regulation S-X, that difference has a prescribed place. Where the LIFO inventory method is used, the excess of replacement or current cost over stated LIFO value must, if material, be stated parenthetically or in a note to the financial statements. A narrower rule covers the case where the method of calculating a LIFO inventory does not allow for the practical determination of amounts assigned to major classes of inventory: those class amounts may then be stated under cost flow assumptions other than LIFO, with the excess of that total over the aggregate LIFO amount shown as a deduction to arrive at the amount of the LIFO inventory. The same section requires the basis of determining the amounts to be stated, and the method by which amounts are removed from inventory, average cost and first-in first-out and last-in first-out among them, to be described (17 CFR 210.5-02).
The same difference turns into a cash tax number when LIFO inventory reaches an S corporation. A C corporation that used LIFO for its last tax year before an S corporation election takes effect, or that transferred LIFO inventory assets to an S corporation in a nonrecognition transaction in which those assets constitute transferred basis property, must include a LIFO recapture amount in gross income. That amount is the amount by which the inventory amount of those assets under first-in, first-out exceeds the inventory amount of the same assets under LIFO at the close of the last year as a C corporation, or at the year of the transfer where the transfer is the trigger (IRS, Form 970, Rev. November 2020).
A Worked Example
Say a client carries an opening layer of stock, buys twice during the year at rising prices, and sells part of what it holds. The same layers produce a different cost of goods sold under each assumption, and the charge lands on the income statement either way.
Opening layer 100 units at $10 1,000
First purchase 100 units at $12 1,200
Second purchase 100 units at $14 1,400
Units sold 150
LIFO, the increase costed in the order of acquisition
cost of goods sold 100 at $14 plus 50 at $12 2,000
ending inventory 100 at $10 plus 50 at $12 1,600
LIFO reserve 400
LIFO, the increase costed at the most recent purchases
cost of goods sold 100 at $12 plus 50 at $14 1,900
ending inventory 100 at $10 plus 50 at $14 1,700
LIFO reserve 300
FIFO
cost of goods sold 100 at $10 plus 50 at $12 1,600
ending inventory 50 at $12 plus 100 at $14 2,000Under either costing of the increase, the gap between the LIFO and the FIFO cost of goods sold is the same size as the gap between the two ending inventory figures, and that gap is the reserve. Reverse the price direction and the effect reverses with it, because falling costs put the newer, lower costs into expense first and leave the higher ones in inventory.
The two LIFO results above differ only in how the increase over the opening layer is costed, and the regulation allows more than one route. That increase may be costed by reference to the actual cost of the goods most recently purchased or produced, by reference to the actual cost of the goods purchased or produced during the taxable year in the order of acquisition, by an average unit cost for the whole year, or by any other proper method that in the Commissioner’s opinion clearly reflects income. Whichever one the taxpayer adopts and the Commissioner approves has to be adhered to consistently in all later years for as long as LIFO is used (26 CFR 1.472-2).
What LIFO Is Commonly Confused With
The physical picking method. In warehousing, cold storage and food distribution, the term names a handling practice: the last pallet or case placed into a rack is the first one retrieved. That describes how stock moves through a building.
The costing method makes no claim about that. Because the regulation assigns cost to the closing inventory regardless of identification with specific invoices and regardless of specific cost accounting records, a business can rotate its oldest stock out of the door first and still be on LIFO for tax and for its books (26 CFR 1.472-2).
Common Questions
Only the order each one assumes. FIFO treats the earliest costs as the first charged to cost of goods sold and leaves the most recent costs in ending inventory. LIFO does the reverse. The units, the invoices and the physical stock are identical either way, and only the assignment of dollars changes.
It is not banned in the United States, where a taxpayer can elect it under 26 U.S.C. 472. It is unavailable under IFRS Accounting Standards. Paragraph 25 of IAS 2 Inventories requires the cost of inventories, other than those dealt with in paragraph 23, to be assigned using the first-in, first-out (FIFO) or weighted average cost formula, and LIFO is not one of the two (IAS 2 Inventories, IFRS Foundation).
If your firm hands inventory-method work to an offshore preparer, a trial task puts a block of your own work through the review chain before any live client file moves.
