GAAP recognizes four inventory valuation methods: specific identification, first-in first-out (FIFO), last-in first-out (LIFO), and weighted average cost. The one you pick drives two numbers readers of your statements care about — the inventory asset on the balance sheet and cost of goods sold on the income statement — and the same purchases can produce meaningfully different results under each method. The rules below cover when each method fits, how the numbers compare, the write-down test that sits on top of all of them, and what it takes to elect or change your method with the IRS.
Specific Identification
Specific identification attaches the actual cost of each individual item to that item through sale. Buy a painting for $500,000, and $500,000 is what hits COGS when it sells. No averaging, no assumptions.
The method only works for high-value, low-volume goods that aren’t interchangeable: custom machinery, fine art, real estate lots, luxury vehicles. The IRS expects you to use specific identification when you can actually match costs to individual items, and to fall back on FIFO, LIFO, or another cost-flow method when items are interchangeable and commingled.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods ASC 330 follows the same logic. Once similar goods bought at different prices lose their individual identity in the warehouse, specific identification stops being appropriate.
There is a manipulation concern baked in. When management chooses which unit to record as sold, they can push reported income up or down by picking a low-cost or high-cost unit. That discretion is exactly why GAAP steers interchangeable-goods businesses toward a cost flow assumption.
First-In, First-Out (FIFO)
FIFO assumes the oldest costs move to COGS first. That usually tracks how goods physically move anyway, since most businesses ship older stock first to avoid spoilage or obsolescence.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods
When prices are rising, FIFO produces the lowest COGS because the oldest, cheapest costs are matched against current revenue. That flows through to higher reported net income. Ending inventory sits on the balance sheet at the most recent purchase prices, giving a fairly current picture of asset value. When costs fall, the effect reverses.
A worked example. You buy 100 units at $10, then 100 units at $12, then sell 150. FIFO draws from the oldest layer first: 100 at $10 plus 50 at $12 equals $1,600 of COGS. The 50 units left carry the newer $12 cost, so ending inventory is $600.
FIFO is the most widely used method globally. It’s one of only two cost formulas permitted under IFRS (weighted average is the other), which matters if you report internationally or expect to.2IFRS Foundation. IAS 2 Inventories
Last-In, First-Out (LIFO)
LIFO assumes the most recent costs move to COGS first. Few businesses actually ship their newest stock before their oldest; the physical flow isn’t the point. LIFO is primarily a tax strategy.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods
In rising-price environments, LIFO matches the newest, highest costs against revenue, which produces the highest COGS and lowest taxable income of any permitted method. Using the same 100 at $10, 100 at $12, sell 150 example: LIFO charges 100 at $12 plus 50 at $10, for $1,700 of COGS. Ending inventory is 50 units at $10, or $500.
The LIFO Conformity Rule
Elect LIFO for tax and you must also use LIFO in any financial statements you issue to shareholders, creditors, or other stakeholders. This is the conformity rule in Section 472.3Office of the Law Revision Counsel. 26 USC 472 – Last-in, First-out Inventories You cannot show the IRS a LIFO-lowered income figure while showing investors a FIFO number.
Violating the rule has teeth. If you use a non-LIFO method in a report to shareholders or for credit purposes, the IRS can terminate your LIFO election for tax purposes entirely.4Internal Revenue Service. LIFO Conformity
The LIFO Reserve and Liquidation Risk
Over years of rising prices, LIFO companies accumulate old inventory layers valued well below current market. The gap between LIFO inventory and what it would be under FIFO is the LIFO reserve, and companies typically disclose it so investors can compare against FIFO peers.
The exposure surfaces during a LIFO liquidation, when you sell more inventory than you replace in a period. Those old, low-cost layers finally hit COGS, producing a spike in reported income and a matching jump in the tax bill. Years of deferred tax can come due at once, which is why supply disruptions and deliberate inventory drawdowns can catch LIFO companies off guard.
LIFO Is Not Available Outside the U.S.
IFRS does not permit LIFO. International reporters are limited to FIFO and weighted average cost, with specific identification reserved for non-interchangeable items.2IFRS Foundation. IAS 2 Inventories U.S. companies on LIFO that report to international stakeholders typically add supplemental disclosures reconciling inventory to a FIFO or average-cost basis.
Weighted Average Cost
Weighted average blends all purchase costs into one average per unit, then applies that figure to both COGS and ending inventory. It fits businesses handling high volumes of homogeneous, interchangeable goods where tracking layers would be pointless: bulk chemicals, commodities, raw materials.
Same example: 100 units at $10 ($1,000) plus 100 units at $12 ($1,200) is $2,200 for 200 units, or $11 per unit. Sell 150 and COGS is $1,650. The 50 units in ending inventory are valued at $550. Both figures land between FIFO and LIFO, which is the point of the method. It smooths price movements rather than amplifying them.
Comparing the Three Cost-Flow Methods
Under rising prices, the pattern from the numbers above holds. FIFO gives the lowest COGS ($1,600) and highest ending inventory ($600). LIFO gives the highest COGS ($1,700) and lowest ending inventory ($500). Weighted average sits in the middle on both ($1,650 and $550). When prices are falling, the relationships flip. When prices are stable, all three methods produce the same result.
Lower of Cost or Net Realizable Value
Once you have a cost figure from one of the methods above, GAAP puts a ceiling on it. Inventory cannot sit on the balance sheet above what you can realistically sell it for. If cost exceeds that value, you write it down now.
For FIFO and weighted average companies, the test compares cost to net realizable value: estimated selling price minus the costs to complete, sell, and ship. If NRV is lower, you cut the inventory’s carrying value and record the difference as an expense in the current period.5Financial Accounting Standards Board. ASU 2015-11 – Inventory (Topic 330) Typical triggers are physical damage, technological obsolescence, and sharp price drops. A computer maker holding laptops at $800 that now sell for $750 after a competitor’s launch writes the units down to $750.
The LIFO and Retail Method Exception
LIFO users and companies on the retail inventory method follow a different version. They compare cost to “market,” which generally means current replacement cost, capped at NRV as a ceiling and floored at NRV minus a normal profit margin. This older “lower of cost or market” framework applied to all inventory before ASU 2015-11 simplified the rule for everyone else.5Financial Accounting Standards Board. ASU 2015-11 – Inventory (Topic 330)
Write-Downs Do Not Reverse
The written-down amount becomes the new cost for all future purposes. Even if market conditions recover next quarter, U.S. GAAP does not let you reverse the write-down. IFRS does allow reversals up to original cost, so this is one of the sharper differences between the two frameworks.
Electing and Changing an Inventory Method
Your inventory method is both an accounting policy and a tax election. Adopting or changing it goes through the IRS.
Electing LIFO
File Form 970 with the tax return for the first year you want LIFO.6Internal Revenue Service. About Form 970 – Application to Use LIFO Inventory Method Once elected, you keep using LIFO in every later year unless the IRS approves a change or revokes the election for a conformity violation.3Office of the Law Revision Counsel. 26 USC 472 – Last-in, First-out Inventories Conformity kicks in the same year, so your financial statements switch to LIFO simultaneously.7Internal Revenue Service. Adopting LIFO
Switching Methods
To change from one inventory method to another after adoption, file Form 3115 (Application for Change in Accounting Method). Many inventory-method changes qualify for automatic consent, meaning the IRS grants approval when you follow the published procedures and file correctly, with no user fee. Non-automatic changes require a user fee and a formal ruling.8Internal Revenue Service. Instructions for Form 3115
Any method change triggers a Section 481(a) adjustment so that income isn’t double-counted or skipped in the transition. A net increase in taxable income is generally spread over four tax years. A net decrease is taken in full in the year of change.9Office of the Law Revision Counsel. 26 USC 481 – Adjustments Required by Changes in Method of Accounting Factor the spread into your cash flow projections before pulling the trigger on a switch.
Small Business Exemption
Not every business has to do full inventory accounting. Under Section 471(c), taxpayers that meet the gross receipts test in Section 448(c) can treat inventory as non-incidental materials and supplies or follow the method used in their financial statements, effectively skipping cost-flow assumptions and deducting inventory costs when the goods are sold or used.10Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
What You Have to Disclose
GAAP requires footnote disclosure of the cost flow method you use, applied consistently period to period. The method must conform to generally accepted practice for similar businesses and clearly reflect income.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods
The balance sheet inventory line is typically broken out by category — raw materials, work-in-process, and finished goods — so readers can see where production stands and how liquid the inventory is.
If you took a write-down under the cost-or-NRV test, substantial or unusual losses should be identified separately rather than buried in COGS.5Financial Accounting Standards Board. ASU 2015-11 – Inventory (Topic 330) LIFO users should disclose the LIFO reserve so investors can restate inventory and COGS on a FIFO-equivalent basis.
When you change inventory methods, disclose the nature and reason for the change in the first reporting period after adoption.5Financial Accounting Standards Board. ASU 2015-11 – Inventory (Topic 330) Investors and analysts watch these carefully, especially switches away from LIFO, because the Section 481(a) adjustment can move reported earnings materially in the transition year.