Inventory Accounting for Small Businesses: FIFO, LIFO, Average Cost, and the Small Business Exception
Inventory accounting determines when the cost of goods sold (COGS) is deducted: when the inventory is purchased or when it’s sold. For most small businesses, the simplified method under IRC 471(c) (enacted by TCJA) eliminates the requirement to track inventory at all, allowing the business to deduct the cost of materials and merchandise when purchased. Businesses that choose to (or must) track inventory select an accounting method that affects taxable income each year.
Inventory accounting options:
Small business exception (IRC 471(c)):
- Available to businesses with average annual gross receipts of $32 million or less (3-year average, for 2026)
- Allows treating inventory as non-incidental materials and supplies
- Deduct inventory costs when purchased (not when sold)
- No separate COGS calculation required
- Can use the cash method of accounting
- Best for: most small businesses, especially service businesses with minor inventory
FIFO (First-In, First-Out):
- Assumes the oldest inventory is sold first
- In a period of rising costs, FIFO produces lower COGS and higher taxable income
- Results in ending inventory valued at the most recent (higher) costs
- Most commonly used method
LIFO (Last-In, First-Out):
- Assumes the newest inventory is sold first
- In a period of rising costs, LIFO produces higher COGS and lower taxable income
- Results in ending inventory valued at the oldest (lower) costs
- Cannot be used for financial reporting (GAAP) without also using it for tax
- Requires LIFO reserve tracking and Form 970 for the first year
Average cost:
- Averages the cost of all units available for sale
- Produces COGS between FIFO and LIFO
- Simpler than tracking individual unit costs
- Common for businesses with fungible inventory (hardware stores, bulk materials)
Specific identification:
- Tracks the actual cost of each specific item sold
- Required for unique or high-value items (custom furniture, art, jewelry)
- Not practical for large volumes of identical items
Which method produces the lowest tax?
Which inventory costing method should my business use?
The three primary methods are FIFO (First In, First Out), LIFO (Last In, First Out), and weighted average cost. FIFO assumes the oldest inventory is sold first, which produces lower cost of goods sold and higher taxable income during periods of rising prices. LIFO assumes the newest inventory is sold first, which produces higher cost of goods sold and lower taxable income during inflation, but LIFO requires a LIFO conformity rule (you must use LIFO for financial reporting if you use it for tax). Small businesses with average gross receipts of $32 million or less (for 2026) can use the cash method and avoid accounting for inventory under IRC 471, treating inventory costs as materials and supplies deductible when consumed. Changing your inventory method requires filing Form 3115 and computing a Section 481(a) adjustment to prevent double-counting or omitting income during the transition.
How often should a small business reconcile its bank accounts?
Monthly reconciliation is the minimum standard. Reconcile every bank and credit card account within the first week after each statement closes. The process compares your internal records (accounting software or ledger) against the bank statement to catch errors, unauthorized charges, and recording mistakes. Businesses with high transaction volume (retail, restaurants, e-commerce) should reconcile weekly or even daily for cash accounts. Unreconciled accounts are the most common source of year-end surprises, missed deductions, and incorrect estimated tax payments. Most accounting software automates the matching, but someone still needs to review and investigate discrepancies.
Related guides:
How often should a small business reconcile its accounts?
Monthly reconciliation is the minimum standard for any business, but weekly reconciliation catches errors faster and makes month-end closing significantly easier. Bank reconciliation compares your accounting records to bank statements to identify timing differences (outstanding checks, deposits in transit) and errors (duplicate entries, missed transactions). Credit card reconciliation should happen monthly at minimum, matching each statement charge to a recorded transaction with the correct expense category and ensuring no unauthorized charges slipped through. Businesses with high transaction volume (retail, restaurants, e-commerce) benefit from daily point-of-sale reconciliation, which catches discrepancies before they compound into material misstatements at year-end.
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Yarik Yarosh, CPA. "Inventory Accounting for Small Businesses: FIFO, LIFO, Average Cost, and the Small Business Exception." Blue Cloud CPA, September 5, 2026, updated October 4, 2026. https://bluecloudcpa.com/guides/small-business-inventory-accounting-methods
This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.