First-In First-Out (FIFO)
An inventory valuation method
What is the First-In-First-Out?
The First-In First-out accounting method is an inventory valuation method. When an item is sold, inventory value must go down. The question is, by how much? This is where inventory valuation methods come in.
As the name suggests, it assumes the value of the item being sold is the value of the first item that went into the inventory in the first place.
Using 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's allowed to use this method 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.
Understanding The First-In-First-Out (FIFO) Method
Companies use the method to evaluate the cost of goods sold (COGS) and inventory value.
This method is based on the assumption that the oldest items were sold first. Using this method, we assume that the first item bought is used to manufacture the first product sold using this method.
It is important to emphasize that, in the method, although the oldest assets or products in the inventory are assumed to be sold first, it is not always the case that the oldest goods are physically disposed of earliest; 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 method shows the current cost of the product based on the most recent item purchased.
- To calculate inventory based on the first-in, first-out method, we should find the first (oldest) items we purchased and multiply them by the number of items.
- Then use this number to calculate the ending inventory value based on this formula:
- Beginning inventory + net purchases - COGS = ending inventory
Let's summarize other ways of evaluating the cost of sales and see an example for each of them:
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
Every item in the inventory has a unique value. This method is commonly used for expensive or specific items, such as a piece of 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).
Inventory Valuation Examples
Let's see how to measure COGS under different Valuation methods according to the table below (we assume a perpetual inventory system for this example):
| Date | Purchased Units | Sold Units | Price per Units |
|---|---|---|---|
| April | 100 | $90 | |
| May | 70 | $95 | |
| June | 110 | $130 | |
| July | 30 | $100 | |
| August | 40 | $150 |
1. FIFO
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
2. 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
3. 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 have to 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), which is on the balance sheet.
These numbers might differ based on the chosen inventory valuation method in an increasing or decreasing price environment.
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The inventory turnover ratio will be higher when LIFO is used during periods of 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.
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Profitability ratios will be smaller under LIFO than under FIFO. The profitability ratios include profit margin, return on assets, and return on stockholders' equity.
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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.
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Using FIFO ensures the value of the reported inventory is a better reflection of the value of the inventory.
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The valuation method affects other items such as gross profit and net income on the income statement as well as current assets and total assets on the Balance Sheet.
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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 associated with it, 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 longer in the inventory using LIFO, you may have to keep records for that item for a longer period.
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 the US GAAP (Generally Accepted Accounting Principals), an accountant is allowed to use FIFO, LIFO, weighted average, and a specific identification method. However, under IFRS (International Financial Reporting Standards), the LIFO method cannot be used.
First-In-First-Out is less complicated than other valuation methods, and companies cannot manipulate income by choosing which unit to ship.
It has a time lag, meaning if the cost of goods suddenly rises, depending on the inventory turnover rate, it may take some time for the COGS on the income statement to show the actual cost of sold goods.
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 called 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 are required to disclose the amount of LIFO reserve (LR) in their financial statement notes or on their Balance Sheet.
LIFO reserve = FIFO Inventory - LIFO Inventory
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.
A company reports the following under LIFO:
| 2022 | 2021 | |
|---|---|---|
| Cost of Goods Sold | $50,000 | $45,000 |
| Cash | $5,000 | $4,000 |
| Inventory | $11,000 | $10,000 |
| LIFO Reserve | $4,000 | $2,500 |
| Retained Earnings | $16,000 | $14,000 |
| Tax | 20% | 20% |
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
How can you tell which companies use which method?
Under the Securities Act of 1933, public companies are required to publish their financial data to the SEC. You can find the companies required to report to the SEC (Securities and Exchange Commission) 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 Form 10-K,10-Q, and 8-K, to name a few.
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 link to their reported financial statements on the SEC on their website.
You can find this information on the annual or quarterly report, 10-Q, and 10-K forms, respectively.
For example, looking at the Apple (AAPL) Form 10-K shows that this company uses the first-in, first-out method.
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