First-In First-Out (FIFO)

What is the First-In-First-Out (FIFO)?

The First-In, First-out accounting method is an inventory valuation method. When an item is sold, its inventory value must decrease. The question is, by how much? This is where inventory valuation methods come in.

As the name suggests, it assumes that the value of the sold item is the value of the first item that went into the inventory. This method aims to ensure that the inventory value is as close as possible to the price of the purchased items.

Most firms with perishable goods, such as food, use this method. This assumption better reflects the reality of the flow of goods in the inventory. First-in-first-out is the most preferred method under IFRS, but it can be used under both IFRS and GAAP standards.

It reflects higher quality information about inventory in the balance sheet, as the value of the inventory on the balance sheet is closer to that of the current market value of the assets.

On the other hand, during a period of high inflation, using this method results in a higher value for the ending inventory and a higher gross profit (compared to other methods). 

This, in turn, results in a higher taxable income for the business and, thus, a higher tax burden. To better understand the method, consider a factory line where the earliest produced item should go out first to open up space for the following item.

How First In, First Out Works

Companies use the method to evaluate the cost of goods sold (COGS) and inventory value. The FIFO method assumes that the oldest items in inventory are sold first, meaning the cost of goods sold is based on the oldest inventory items.

In the FIFO method, although the assumption is that the oldest inventory items are sold first, it does not require the physical disposal of those specific items before newer ones.

It is merely that the cost associated with the oldest goods present in the inventory is expended first on the balance sheet.

The ending inventory value derived from the FIFO method reflects the cost of the remaining inventory based on the oldest items purchased. To calculate inventory under the FIFO method, sum the costs of all inventory units sold during the period, prioritizing the cost of the oldest items.

Then, use this number to calculate the ending inventory value based on this formula:

Beginning Inventory + Net Purchases - COGS = Ending Inventory

Other Inventory Valuation Methods

There are different methods other than First-In-First-Out, including:

1. LIFO (Last-In, First-Out): The last (newest) item purchased or manufactured is the first one that should go out. Imagine manufactured items are piling up on top of each other, so if you want to pick one, you should pick the top (newest or the last) one
2. Specific Identification method: The specific identification method assigns a unique value to each item in the inventory, commonly used for various items, including expensive or specific ones like jewelry
3. Weighted Average Cost (WAC): The average cost of the goods in the inventory is assumed to represent each item's cost (total cost of goods/total units)

FIFO Example

Let's see how to measure COGS under different FIFO and other Valuation methods according to the table below (we assume a perpetual inventory system for this example):

We sold 110 units in June. So take 100 units from April's purchases and ten units from May's:

COGS = 100 * 90 + 10 * 95 = 9000 + 950 = $9950

We sold another 40 units in August (remember we still have 60 units from May), so we take these items from May's purchase:

COGS = 40 * 95 = $3800

Total COGS (FIFO) = 9950 + 3800= $13750

Ending Inventory= 20 (May) * 95 + 30 (July) *100 = $4900

Other Inventory Valuations

Let's understand the other methods by using the same example above:

1. LIFO

June's sale is 110 units. Take 70 units from May and 40 units from April:

COGS = 70 * 95 + 40 * 90= 6650 + 3600 = $10250

We purchased 30 units in July and sold 40 units in August:

COGS = 30 * 100 + 10 * 90 = 3000 + 900 = $3900

Total COGS (LIFO) = 10250 + 3900 = $14150

We are left with 50 units from April.

Ending Inventory = 50 * 90 = $4500

2. Weighted Average Cost (WAC)

Average costs for June = (100 * 90 + 70 * 95)/ 170 = $92.06

COGS= 110 * 92.06 = $10126.6

Inventory= 60 * 92.06 = $5523.6

We have a purchase record in July, so we must recalculate the average cost.

Average Cost for August = (5523.6 + 100*30)/ 90 = $94.71

COGS = 40 * 94.71 = $3788.4

Ending Inventory = 50 * 94.71 = $4735.5

Total Cost of Sales (WAC) = 10126.6 + 3788.4 = $13915

Here's another example of calculating the cost of sales by the First-In, First-Out method:

Impact of FIFO Inventory Valuation Method on Financial Statements

First-in-first-out (and other valuation methods) measure COGS in the income statement and ending inventory value (EI) on the balance sheet. 

These numbers might differ based on the chosen inventory valuation method in an increasing or decreasing price environment.

• The inventory turnover ratio will be higher when LIFO is used during increasing costs. The reason is that the cost of goods sold will be higher, and the inventory costs will be lower under LIFO than under FIFO
• Profitability ratios will be smaller under LIFO than under FIFO. The profitability ratios include profit margin, return on assets, and return on stockholders' equity
• Using LIFO and reporting higher COGS if the price of goods is rising leads to reporting less gross profit and has the advantage of reporting less tax
• Using FIFO ensures the value of the reported inventory is a better reflection of the value of the inventory
• The valuation method affects other items on the income statement, such as gross profit and net income, as well as current assets and total assets on the Balance Sheet
• For financial reports written under GAAP, the difference between the First-In-First-Out method and the Last-In-First-Out method should be disclosed under LR (LIFO Reserve)

FIFO vs. LIFO

Let's assume we are in an inflationary economy. With the LIFO method, every item entering the inventory would have a higher price, leading to a higher COGS, resulting in a lower gross profit in the income statement. From a tax perspective, lower gross profit means lower tax expenses (check the examples above).

Another difference is the record-keeping period. Since older items may remain in the inventory longer using LIFO, so you may have to keep records of those items for longer.

Under FIFO, reported inventory is more likely to approximate the current market value of the inventory.

Financial reporting standard is another difference between these inventory valuation methods.

Under US GAAP (Generally Accepted Accounting Principles), an accountant can use FIFO, LIFO, weighted average, and a specific identification method. However, the LIFO method cannot be used under IFRS (International Financial Reporting Standards).

First-in-first-out is less complicated than other valuation methods, and companies cannot manipulate income by choosing which unit to ship.

Changing from LIFO to FIFO

You probably wondered if we use LIFO, don't we under-value the inventory? Where does the extra inventory we didn't add show up? You wondered, right?

Another item, LIFO Reserve (LR), explains the difference between the two inventory values. 

Some companies use the LIFO method for their inventory management system. Under US GAAP, these companies must disclose the LIFO reserve (LR) amount in their financial statement notes or Balance Sheet.

LIFO reserve = FIFO Inventory - LIFO Inventory 

Steps

So, to compare financial reports from two companies with different valuation methods, some of the items have to change:

Add back the LR to the FIFO amount (balance sheet):

FIFO Inventory = LIFO Inventory + LR

Deduct the difference (Δ) of LR between two balance sheet dates from COGS (income statement):

COGS (FIFO) = COGS (LIFO) – Δ LR

We have some extra cash because of tax savings under LIFO. Deduct these:

LR * Tax Rate

Retained earnings of shareholder's equity should increase by this amount:

LR * (1 - T)

Remember: Both sides of the balance sheet should be equal.

Example

A company reports the following under LIFO:

Let's calculate Income Statement and Balance sheet changes for 2022:

Δ LR = $4,000 - $2,500 = $1,500

Cost of Goods Sold (FIFO) = $50,000 - $1,500 = $48,500

Inventory = $11,000 + $4,000 = $15,000

Cash = $5,000 - $4,000 * 0.2 = $4,200

Retained Earning = $16,000 + $4,000 * (1 - 0.2) = $19,200

Identifying the Valuation Method

Under the Securities Act of 1933, public companies must publish their financial data to the SEC (Securities and Exchange Commission). The companies required to report to the SEC can be found on EDGAR.

According to the SEC's' definition, EDGAR, or the Electronic Data Gathering, Analysis, and Retrieval system, is the primary system for companies and others submitting documents under the Securities Act of 1933, the Securities Exchange Act of 1934, the Trust Indenture Act of 1939, and the Investment Company Act of 1940.

The EDGAR database provides free public access to corporate information, including Forms 10-K,10-Q, and 8-K.

The inventory methods used by the companies whose stock is publicly traded are under the Summary of Significant Accounting Policies Form 10-K. The Summary of Significant Accounting Policies appears as the first or second item in the Notes section of the financial statements.

Some companies have a website link to their reported financial statements on the SEC. This information is found on the annual or quarterly report, 10-Q, and 10-K forms, respectively. For example, Apple's (AAPL) Form 10-K shows that this company uses the first-in, first-out method.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Inventory Valuation
• Last-In First-Out (LIFO)
• LIFO Liquidation
• LIFO vs. FIFO
• Variable Costing