Inventory Accounting for Small Businesses: FIFO, LIFO, Average Cost, and the Small Business Exception

Inventory accounting options:

Small business exception (IRC 471(c)):

• Available to businesses with average annual gross receipts of $30 million or less (3-year average)
• 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