What Is LIFO?
LIFO is a cost-flow assumption under which the most recently purchased inventory is treated as sold first, leaving the oldest costs sitting on the balance sheet. It rarely matches the physical movement of goods; instead, it exists mainly as a tax strategy. When purchase prices rise over time, expensing the newest, most expensive units first pushes cost of goods sold up and taxable income down.
US tax law enforces a conformity rule: a company that elects LIFO for its tax return must also use it in its financial statements, so investors see the same lower earnings the IRS does. Because IFRS bans LIFO outright, companies with global reporting obligations or foreign listings generally avoid it, and its use has been slowly declining.
How LIFO Works, Including the LIFO Reserve
Take a distributor that buys 100 units at $10 early in the year and 100 units at $12 later on, then sells 100 units. Under LIFO, COGS is 100 × $12 = $1,200 and ending inventory is carried at $1,000. Compared with FIFO, pre-tax income is $200 lower, and at a 25% tax rate the company keeps an extra $50 of cash this year.
GAAP requires LIFO users to disclose a LIFO reserve, the difference between what inventory would be worth under FIFO and its LIFO carrying value. Analysts add the reserve back to restate inventory and equity on a comparable basis. One quirk to know is LIFO liquidation: if a company sells down old inventory layers, decades-old low costs flow into COGS and can artificially inflate margins for a period.
Why LIFO Matters in Practice
LIFO's appeal is entirely about cash. During the inflation spike of 2021 and 2022, companies with large commodity-linked inventories saved meaningful tax dollars by expensing high current costs immediately. The cumulative deferral embedded in LIFO reserves at large industrial and energy distributors can run into the hundreds of millions of dollars, effectively an interest-free loan from the government.
For interviews, be ready to state the directional effects: in a rising price environment LIFO means higher COGS, lower net income, lower taxes paid, and understated inventory relative to FIFO. Also know the comparability fix — use the disclosed LIFO reserve to adjust — and the headline structural fact that IFRS filers cannot use LIFO at all.
