Fifo accounting

What Is FIFO Accounting?

FIFO accounting, standing for "First-In, First-Out," is an inventory accounting method that assumes the first goods purchased or produced by a company are the first ones to be sold, used, or removed from inventory. This cost flow assumption directly impacts how a company values its unsold inventory and calculates its cost of goods sold (COGS). It is one of several accepted methods for inventory valuation under accounting principles, widely applied in various industries to manage the flow of goods and present financial performance. The FIFO method typically aligns with the physical flow of goods for businesses dealing with perishable items or those with a high turnover rate, such as grocery stores or fashion retailers.

History and Origin

The concept of tracking and valuing inventory dates back to ancient civilizations, where early forms of record-keeping like tally sticks and clay tokens were used to manage goods.²¹, ²² As commerce evolved, so did the need for more sophisticated accounting practices to accurately reflect a business's financial position. While the precise historical origin of the FIFO accounting method as a formalized principle is not pinpointed to a single event or inventor, its development runs parallel to the evolution of modern accounting standards, particularly in the 20th century. The widespread adoption of various inventory costing methods, including FIFO, became crucial as businesses grew in complexity and the need for standardized financial reporting emerged. These methods provide a systematic way to assign costs to inventory, moving beyond simple physical counts to address the economic realities of fluctuating purchase prices.

Key Takeaways

• FIFO accounting assumes that the oldest inventory items are sold first, impacting the calculation of cost of goods sold and the valuation of remaining inventory.
• This method generally results in a higher reported net income and higher ending inventory values during periods of inflation.
• It often aligns with the natural physical flow of goods, particularly for perishable products or those with limited shelf lives.
• FIFO is accepted under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Formula and Calculation

The FIFO accounting method does not involve a single formula in the traditional sense, but rather a principle for assigning costs. The calculation involves identifying the cost of the earliest purchased or produced units and assigning those costs to the units sold. The remaining units in inventory are then valued at the cost of the most recently acquired items.

To calculate the Cost of Goods Sold (COGS) using FIFO:

To calculate Ending Inventory using FIFO:

For example, if a company sells 50 units, and its first 30 units purchased cost $10 each, and the next 40 units cost $12 each, the COGS calculation using FIFO would assign the cost of the first 30 units and then 20 units from the next batch. The inventory value on the balance sheet reflects the most recent costs.

Interpreting the FIFO Method

Interpreting the FIFO accounting method requires understanding its impact on a company's financial statements, particularly the income statement and balance sheet. In an environment of rising prices (inflation), FIFO typically results in a lower cost of goods sold because it assigns the older, presumably cheaper, costs to the units sold. This, in turn, leads to a higher reported gross profit and net income. Conversely, the ending inventory balance on the balance sheet will reflect the most recent, higher costs, thereby presenting a higher value for current assets.

This method is often seen as providing a more accurate representation of the actual physical flow of inventory for many businesses, especially those dealing with goods that have a limited shelf life or where chronological selling is standard practice.

Hypothetical Example

Consider "Gadget Co.," a retailer of electronic accessories. On January 1, Gadget Co. has 100 units of a specific USB charger in inventory, purchased at $5.00 each.

• On January 15, Gadget Co. purchases another 150 units at $6.00 each.
• On January 25, Gadget Co. sells 120 units of the USB charger.

To calculate the cost of goods sold using FIFO accounting:

1. The first 100 units sold are assumed to be from the January 1 batch (oldest inventory).
   • 100 units * $5.00/unit = $500
2. The remaining 20 units (120 total sold - 100 from first batch) are assumed to be from the January 15 batch.
   • 20 units * $6.00/unit = $120

Therefore, the total cost of goods sold for January 25 is $500 + $120 = $620.

To calculate the ending inventory:

1. Gadget Co. started with 100 + 150 = 250 units.
2. After selling 120 units, 250 - 120 = 130 units remain.
3. These 130 units are assumed to be from the most recent purchases. Since 150 units were purchased on January 15 at $6.00, and only 20 were sold from this batch, 130 units (150 - 20) remain from this batch.
   • 130 units * $6.00/unit = $780

The ending inventory balance for the USB chargers would be $780. This step-by-step approach illustrates how FIFO consistently matches the oldest costs with sales and leaves the newest costs in ending inventory.

Practical Applications

FIFO accounting is widely used across various industries, particularly where the physical flow of inventory naturally follows a "first-in, first-out" pattern. This includes:

• Retail: Grocery stores, fashion boutiques, and electronics retailers often use FIFO because older items are typically sold before newer ones to prevent spoilage, obsolescence, or simply to clear older stock.
• Food and Beverage: Companies dealing with perishable goods rely heavily on FIFO to ensure that products are sold before their expiration dates, minimizing waste and maintaining product freshness.
• Pharmaceuticals: Due to strict shelf-life requirements, pharmaceutical companies commonly employ FIFO to manage their drug inventory, ensuring that the oldest medications are distributed first.
• Manufacturing: For components and raw materials that degrade over time or become obsolete, FIFO helps ensure that the oldest stock is consumed in production first.

From a regulatory standpoint, the U.S. Internal Revenue Service (IRS) permits the use of FIFO for tax purposes.¹⁹, ²⁰ Companies must consistently apply their chosen inventory method once elected, and any change requires IRS approval.¹⁷, ¹⁸ The Financial Accounting Standards Board (FASB) also provides comprehensive guidance on inventory accounting, including FIFO, under ASC 330.¹⁵, ¹⁶

Limitations and Criticisms

While FIFO accounting offers clear advantages, particularly its alignment with the physical flow of goods for many businesses, it also has limitations and faces criticisms.

One primary criticism arises during periods of significant inflation. In such an environment, FIFO matches older, lower inventory costs with current revenues, resulting in a higher reported gross profit and taxable income. This can lead to a higher tax liability for the company, potentially reducing its cash flow.¹³, ¹⁴

Another limitation is that while FIFO presents a balance sheet inventory value that closely reflects current market costs (because the remaining inventory is valued at recent purchase prices), it may not provide the most accurate matching of current costs with current revenues on the income statement during inflationary periods. This can sometimes lead to what is termed "phantom profit," where reported earnings are inflated due to the use of older, lower costs, rather than reflecting the true economic cost of replacing the goods sold.¹²

Furthermore, choosing an inventory method can have a notable impact on a company's perceived financial health. Companies using FIFO during inflationary times may appear more profitable and have higher current assets, which could be advantageous for attracting investors or securing credit. However, this appearance might not fully capture the real cost pressures faced by the business.¹¹

FIFO Accounting vs. LIFO Accounting

FIFO (First-In, First-Out) and LIFO accounting (Last-In, First-Out) are two fundamental inventory costing methods that assume different flows of goods for accounting purposes, leading to distinct impacts on financial statements. The core difference lies in which inventory costs are assigned to the cost of goods sold and which remain in ending inventory.

In inflationary periods, a key differentiator is the tax implication: LIFO generally leads to a higher COGS and thus lower taxable income and tax liability compared to FIFO. Conversely, FIFO results in a lower COGS and higher taxable income.⁶, ⁷ This difference in tax implications is a significant factor for companies when choosing between the two methods, especially in the U.S., where the IRS permits both.⁴, ⁵ However, the global accounting landscape differs, as IFRS explicitly prohibits the use of LIFO, meaning companies reporting under IFRS must use FIFO or another method like the weighted-average method.¹, ², ³

FAQs

Why do companies use FIFO?

Companies use FIFO because it generally aligns with the physical flow of goods, especially for perishable items or those with a high turnover. It also presents a more realistic value of ending inventory on the balance sheet by valuing it at the most recent costs.

Does FIFO result in higher or lower taxes?

During periods of rising prices (inflation), FIFO typically results in a lower cost of goods sold and, consequently, a higher reported net income. This higher income usually translates to a higher tax liability compared to the LIFO method.

Is FIFO mandatory?

FIFO is not universally mandatory. In the U.S., under Generally Accepted Accounting Principles (GAAP), companies can choose between FIFO, LIFO, or the weighted-average method for inventory valuation. However, under International Financial Reporting Standards (IFRS), FIFO is one of the permitted methods, and LIFO is explicitly prohibited.

What industries commonly use FIFO?

Industries that frequently use FIFO include grocery stores, fashion retail, pharmaceuticals, and any business dealing with perishable goods or products that are prone to obsolescence. This ensures that older inventory is sold or used first, minimizing spoilage and maximizing freshness or relevance.