Title: What Is the FIFO Method? A Practical Guide to First In, First Out Inventory Valuation
Key takeaways
– FIFO (First In, First Out) assumes the oldest inventory items are sold first and the newest remain in ending inventory.
– Under FIFO in inflationary periods, older (lower) costs are charged to cost of goods sold (COGS), producing higher gross profit and higher ending inventory than LIFO.
– FIFO is accepted under U.S. GAAP and required under IFRS; LIFO is not permitted under IFRS.
– Implementation requires clear policy, consistent recordkeeping, proper accounting system settings (perpetual or periodic), and appropriate financial statement disclosures.
Sources: Investopedia — FIFO definition and examples (https://www.investopedia.com/terms/f/fifo.asp); IRS Publication 538, Accounting Periods and Methods (https://www.irs.gov/publications/p538); AICPA guidance on IFRS vs U.S. GAAP.
What FIFO means (plain language)
FIFO stands for First In, First Out. It is an inventory cost-flow assumption that assigns the cost of the oldest purchased (or produced) inventory to the items sold first. Ending inventory is therefore valued using the most recent purchase costs.
Why companies use FIFO
– Reflects physical flow for many businesses (grocers, perishables).
– Produces inventory values on the balance sheet that are closer to current replacement cost.
– Easier to understand and less prone to manipulation than some alternatives.
– Required by IFRS and widely used internationally.
How FIFO works — conceptual and operational view
– Conceptually: When you sell units, remove cost layers starting with the oldest purchases.
– Operationally there are two common systems:
– Perpetual FIFO: Inventory and COGS are updated continuously as each sale occurs; the system removes units from the oldest cost layer at the moment of sale.
– Periodic FIFO: You record purchases to a purchases account and, at period end, compute COGS by assigning the oldest unit costs to units sold during the period.
Simple numeric example (step-by-step)
Assume:
– Purchase A: 100 units @ $10 each = $1,000
– Purchase B: 100 units @ $15 each = $1,500
Inventory on hand = 200 units, total cost $2,500.
1) Sell 60 units.
– Under FIFO, COGS = 60 × $10 = $600 (from Purchase A).
– Remaining inventory: 40 units @$10 + 100 units @$15 = $400 + $1,500 = $1,900.
2) Sell additional 50 units.
– Next 40 units come from remaining @$10 layer: 40 × $10 = $400.
– Next 10 units come from @$15 layer: 10 × $15 = $150.
– Total COGS for this sale = $550.
– Remaining inventory after both sales: 90 units @$15 = $1,350.
Journal entries (perpetual system)
– Purchase inventory: Debit Inventory $1,000; Credit Cash/AP $1,000 (and another entry for the $1,500 purchase).
– Sale (assume sale price collected separately):
– Debit Cash/AR (sale price), Credit Sales Revenue (sale price).
– Debit Cost of Goods Sold $600; Credit Inventory $600 (for the first sale of 60 units).
– For the second sale, debit COGS $550; credit Inventory $550.
How FIFO is calculated (algorithm)
– Determine quantity sold.
– Starting with the oldest purchase lot, allocate units to sales until that lot is exhausted; move to the next oldest lot as needed.
– COGS = sum(cost × units taken from each lot).
– Ending inventory = sum(cost × units remaining in each lot).
Perpetual vs periodic calculation differences
– Perpetual: Allocation performed at each sale; inventory layers updated continuously.
– Periodic: Compute COGS at period end: COGS = Beginning inventory + Purchases − Ending inventory (ending inventory valued under FIFO by allocating the most recent costs to the units remaining).
FIFO vs LIFO vs other methods (short comparison)
– FIFO: Oldest costs → COGS; newest costs → ending inventory. Higher net income in inflationary times; higher ending inventory valuation.
– LIFO (Last In, First Out): Newest costs → COGS; oldest costs → ending inventory. Lower net income and lower taxable income in inflationary periods. Not allowed under IFRS; permitted under U.S. GAAP (subject to rules).
– Weighted Average Cost: Assigns average cost to all units; yields results between FIFO and LIFO in inflationary periods.
– Specific identification: Tracks actual cost of each specific item (used for unique/high-value items).
Advantages of FIFO
– Logical and intuitive; often matches actual physical flow for many products.
– Ending inventory reflects recent costs—better balance sheet representation.
– Easier to implement and audit; less susceptible to manipulative cost-shifting.
– Accepted under IFRS and U.S. GAAP.
Disadvantages of FIFO
– In inflationary environments, FIFO reports higher profits and therefore often higher income taxes compared with LIFO.
– May not match actual physical flow for certain industries (e.g., high-tech components where older inventory may be retained).
– Can overstate profitability if replacement costs are rising.
Tax and financial-statement implications
– In inflationary times:
– FIFO → lower COGS, higher gross profit and net income, higher ending inventory.
– LIFO → higher COGS, lower net income, lower taxes (where LIFO is allowed).
– LIFO is not permitted under IFRS; companies with IFRS reporting must use FIFO or another permitted method.
– Changing inventory accounting methods can require approval from tax authorities (for U.S. tax purposes, see IRS Publication 538 on accounting method changes).
When FIFO is most appropriate
– Businesses with perishable goods or natural physical FIFO flow (groceries, pharmaceuticals).
– Companies wanting ending inventory to approximate current costs.
– Firms that report under IFRS or those preferring simplicity and transparency.
Practical steps to implement FIFO in a business
1. Decide and document the inventory valuation policy in accounting policy documentation — state FIFO, whether perpetual or periodic.
2. Configure your accounting/inventory system (ERP, POS) to use FIFO costing for inventory valuation and COGS calculations.
3. Establish lot-tracking or batch identifiers if you need to trace physical receipts and movements.
4. Train warehouse and accounting staff on physical flow controls so physical movement aligns reasonably with the cost-flow assumption.
5. Perform regular cycle counts and periodic physical inventory to reconcile system quantities and costs.
6. Reconcile inventory subsidiary ledgers to the general ledger each period; investigate cost-layer anomalies.
7. Disclose the inventory valuation method and any periodic changes in accounting policies in financial statement notes.
8. If changing methods (e.g., from LIFO to FIFO), consult tax advisors and follow IRS and accounting-guidance procedures for method changes and disclosures.
Audit and documentation considerations
– Maintain purchase records, lot receipts, and movement logs that demonstrate how costs were allocated to COGS.
– Keep clear reconciliations of cost layers, especially around period ends.
– Prepare disclosures on method selection and effects of inflation or significant price changes.
When to consider alternatives
– If managing tax liabilities in high-inflation environments and LIFO is allowed, evaluate LIFO for tax deferral benefits.
– Consider weighted-average or specific identification if items are indistinguishable or uniquely identifiable/high-cost.
The bottom line
FIFO is a widely used, transparent inventory-costing method that assigns the oldest costs to COGS and the newest costs to ending inventory. It aligns well with many companies’ physical flows and financial reporting goals, but it can increase reported income (and taxes) during inflation. Implementation requires clear policy, proper system configuration, inventory controls, and disclosure in financial statements.
Further reading and references
– Investopedia — First In, First Out (FIFO): https://www.investopedia.com/terms/f/fifo.asp
– Internal Revenue Service — Publication 538, Accounting Periods and Methods: https://www.irs.gov/publications/p538
– AICPA — Is IFRS That Different From U.S. GAAP? (overview guidance on IFRS differences)
If you want, I can:
– Walk through your company’s specific purchases/sales and compute FIFO COGS and ending inventory.
– Provide sample journal entries tailored to perpetual vs periodic systems.
– Draft an inventory policy statement paragraph for your accounting manual.