Inventory Accounting for Small Business: FIFO, LIFO, and When You Don't Need to Track Inventory

By Yarik Yarosh, CPA ·September 5, 2026 ·5 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

Businesses that produce, purchase, or sell merchandise must generally account for inventory and use the accrual method of accounting under IRC 471. However, the TCJA created a major exception: small businesses with average annual gross receipts of $29 million or less (2025 inflation-adjusted threshold from IRC 448(c)) can use the cash method of accounting and treat inventory as non-incidental materials and supplies, effectively deducting inventory costs when paid rather than when sold. For businesses that do track inventory, the three primary cost-flow methods are FIFO (first-in, first-out), LIFO (last-in, first-out), and weighted average cost. The choice of method directly affects cost of goods sold (COGS), taxable income, and tax liability, especially during periods of rising or falling prices.

✓Key takeaway

Inventory accounting methods comparison:

Method	How It Works	Effect During Inflation	Tax Impact
FIFO (first-in, first-out)	Oldest inventory sold first	Lower COGS, higher profit	Higher taxes
LIFO (last-in, first-out)	Newest inventory sold first	Higher COGS, lower profit	Lower taxes
Average cost	Weighted average of all units	Middle ground	Middle ground
Specific identification	Track each item individually	Depends on which items sold	Flexible but complex

Small business exception (IRC 471(c)):

Factor	Details
Threshold	Average annual gross receipts $29 million or less (2025)
Effect	Can use cash method, treat inventory as materials/supplies
Deduction timing	Deduct when paid (not when sold)
Who qualifies	Sole props, S-Corps, partnerships, C-Corps under threshold
Who doesn’t qualify	Tax shelters, any business over the $29M threshold

When each method is best:

Method	Best For
FIFO	Businesses with perishable inventory (food, flowers), or when prices are falling
LIFO	Businesses with rising costs (building materials, commodities) wanting to minimize taxes
Average cost	Businesses with fungible inventory (hardware, bulk goods), simplicity preferred
Cash method (under $29M)	Small businesses wanting simplicity and immediate deductions
Specific identification	High-value, unique items (cars, jewelry, art)

How does inventory method choice affect taxes?

Hypothetical example

Round numbers. A hardware store. S-Corp. Sells fasteners and small parts. Annual revenue: $500,000. Under the $29M threshold.

Option A: Use the small business exception (cash method) The store treats inventory as materials and supplies. Purchases are deducted when paid.

Month	Inventory Purchased	Inventory Sold (revenue)	Cash Deduction
January	$20,000	$15,000	$20,000
June	$25,000	$30,000	$25,000
November	$30,000 (holiday stock-up)	$20,000	$30,000
December	$5,000	$40,000	$5,000
Total	$80,000	$105,000	$80,000

Under the cash method, all $80,000 in purchases are deducted in the year paid, regardless of how much inventory remains unsold at year end. If $15,000 of the November stock-up remains unsold at December 31, the store still deducts the full $80,000.

Taxable income from inventory: $105,000 revenue - $80,000 COGS = $25,000

Option B: FIFO (accrual method)

Item	Amount
Beginning inventory	$10,000
Purchases	$80,000
Goods available for sale	$90,000
Ending inventory (at oldest costs, FIFO)	$25,000
COGS	$65,000

Taxable income: $105,000 - $65,000 = $40,000

Option C: LIFO (accrual method)

Item	Amount
Beginning inventory	$10,000
Purchases	$80,000
Goods available for sale	$90,000
Ending inventory (at oldest costs, LIFO, lower because newer/higher costs are in COGS)	$18,000
COGS	$72,000

Taxable income: $105,000 - $72,000 = $33,000

Comparison:

Method	COGS	Taxable Income	Tax (24% bracket)
Cash method (small business exception)	$80,000	$25,000	$6,000
FIFO	$65,000	$40,000	$9,600
LIFO	$72,000	$33,000	$7,920

The cash method saves $3,600 per year compared to FIFO. Over 10 years: $36,000 in tax savings, simply by electing the small business exception.

Why wouldn’t every small business use the cash method?

Consideration	Details
Financial statements	Banks and lenders often require accrual-based financials with proper inventory accounting
Business valuation	Inventory is an asset; the cash method understates assets
LIFO conformity	LIFO requires the same method on financial statements (if financial statements use FIFO, tax return can’t use LIFO)
Growing inventory	Cash method front-loads deductions; if inventory is growing, this accelerates deductions significantly
Shrinking inventory	If inventory levels decrease, the cash method provides fewer benefits

The LIFO conformity rule: LIFO has a unique requirement: if a business elects LIFO for tax purposes, it must also use LIFO on any financial statements issued to shareholders, creditors, or other external users (IRC 472(c)). This means:

Bank loan applications must show LIFO inventory
Financial statements given to potential buyers must use LIFO
Internal reports to partners/shareholders must use LIFO

FIFO and average cost have no such conformity requirement.

Section 263A (UNICAP) for manufacturers: Businesses that manufacture goods (not just resell) must capitalize certain indirect costs into inventory under the uniform capitalization rules (IRC 263A). These include:

Must Capitalize (add to inventory cost)	Can Expense Immediately
Direct materials	Selling expenses
Direct labor	Distribution costs
Factory overhead (rent, utilities, depreciation)	Marketing
Quality control	General administrative (not related to production)
Purchasing costs	Research and development
Storage costs (for production)

The small business exception ($29M threshold) also exempts businesses from UNICAP. This is a significant simplification for small manufacturers.

Illustrative numbers only, not a real client and not advice for your facts.

Want this checked against your own situation?

Start with a Diagnostic: a CPA licensed in the US and Canada reads your file and answers in writing, three to four business days after you finish the questions. $250 for cross-border, $195 for a second opinion on a filed return, and it comes straight off the bill if we do the work after. Or book a free 15-minute fit call first.

Start a Diagnostic →Book a free call

Get the next cross-border guide by email

One or two plain-English guides a week on US-Canada tax. No spam, unsubscribe anytime.

Cite this page

Yarik Yarosh, CPA. "Inventory Accounting for Small Business: FIFO, LIFO, and When You Don't Need to Track Inventory." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-inventory-accounting-methods-fifo-lifo

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.