First In, First Out (FIFO)

Definition

First In, First Out (FIFO)

The First In, First Out (FIFO) method is an accounting approach used for inventory valuation and cost of goods sold (COGS) calculations. Under FIFO, it is assumed that the first items placed into inventory are the first ones sold. This means that the oldest costs are moved to COGS, and the remaining inventory is valued at the most recent costs.

FIFO is important during periods of inflation as it affects financial statements by inflating profits. Since the oldest (and usually least expensive) inventory costs are used to calculate COGS, the remaining inventory is valued at higher prices, thereby increasing assets on the balance sheet and inflating profits.

Examples

Retail Store: A clothing store purchases shirts at $10 in January, $12 in February, and $15 in March. If the store sells 100 shirts in April, under the FIFO method, the cost of goods sold (100 x $10) will be based on the oldest cost, i.e., $1000.
Manufacturing: A car manufacturer purchases steel at different rates over the year. If the company uses the FIFO method, the first batch of cars sold will reflect the cost of the steel bought first, even if the steel purchased later is more expensive due to inflation.

Frequently Asked Questions (FAQs)

What is the difference between FIFO and LIFO?

FIFO (First In, First Out) assumes the oldest inventory is sold first, while LIFO (Last In, First Out) assumes the most recent inventory is sold first. The choice between FIFO and LIFO can impact financial statements differently, especially during periods of price changes.

Can FIFO be used for both financial accounting and tax purposes?

Yes, FIFO can be used for both financial accounting and tax reporting purposes. However, the choice of method should be consistent across periods to ensure reliable financial reporting.

How does FIFO affect the income statement?

During inflationary periods, FIFO results in lower COGS and higher gross profit because the costs of older, cheaper items are matched against current revenues. Conversely, in deflationary periods, FIFO may lead to higher COGS and lower profits.

Why might a company choose FIFO?

Companies might choose FIFO to match inventory costs with the actual physical flow of goods, enhance profitability during inflation, and present a higher value of ending inventory on the balance sheet.

How does FIFO impact the balance sheet?

FIFO allocates the most recent costs to ending inventory, leading to higher asset valuation on the balance sheet during periods of rising prices.

Last In, First Out (LIFO)

A method of inventory valuation where the cost of the latest inventory items purchased is used first to calculate COGS. Unlike FIFO, LIFO assumes that the most recent inventory costs are moved to COGS.

Average Cost Method

An inventory valuation method calculating COGS and ending inventory based on the average cost of all units available for sale during the period.

Weighted Average Cost

A variant of the average cost method, it assigns an average cost to each unit of inventory, weighted by the quantity of units.

Gross Profit

The difference between sales revenue and COGS. FIFO can result in higher gross profit during inflationary periods because it allocates older, cheaper costs to COGS.

Online References

Suggested Books for Further Studies

“Financial Accounting” by Jerry J. Weygandt, Donald E. Kieso, and Paul D. Kimmel
“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
“Accounting Principles” by Weygandt, Kimmel, and Paul
“Managerial Accounting” by Ray H. Garrison, Eric Noreen, and Peter Brewer

Fundamentals of FIFO: Accounting Basics Quiz

### What does FIFO stand for? - [x] First In, First Out - [ ] Fast Inventory Forecasting - [ ] Fiscal Inventory First - [ ] None of the above > **Explanation:** FIFO stands for First In, First Out, an inventory valuation method where the earliest goods purchased are the first to be sold. ### How does FIFO affect the cost of goods sold during inflation? - [ ] Decreases COGS - [x] Increases COGS - [ ] Has no effect - [ ] Decreases and then increases COGS > **Explanation:** During periods of inflation, FIFO results in lower COGS because older, cheaper costs are moved to COGS first, effectively increasing the profits. ### In FIFO, what cost is assigned to goods sold? - [x] The oldest cost available - [ ] The latest cost available - [ ] An average cost of all items - [ ] None of the above > **Explanation:** FIFO assigns the oldest cost available to goods sold, which reflects the historical price of the first units placed into inventory. ### How does FIFO affect the income statement during inflation? - [x] Increases profits - [ ] Decreases profits - [ ] Has no effect on profits - [ ] Exaggerates expenses > **Explanation:** FIFO can increase profits during inflation because older, lower costs are used to calculate COGS, leading to a higher gross profit. ### Which of the following is a benefit of using FIFO? - [x] Higher ending inventory value during inflation - [ ] Lower ending inventory value during inflation - [ ] Less administrative effort - [ ] Consistent costs > **Explanation:** FIFO's primary benefit during inflation is that it results in a higher ending inventory value, presenting a stronger asset position on the balance sheet. ### FIFO method is typically... - [x] Used to match the physical flow of inventory - [ ] Counter-intuitive - [ ] Rarely used - [ ] Illegal > **Explanation:** FIFO is commonly used to match the actual physical flow of inventory, especially in industries where older items are sold first. ### How does FIFO impact taxes during inflation? - [ ] Lowers taxable income - [x] Increases taxable income - [ ] Eliminates taxes - [ ] Has no impact on taxes > **Explanation:** FIFO increases taxable income during inflation because it results in higher reported profits, leading to a higher tax liability. ### Can FIFO and LIFO be used simultaneously? - [ ] Yes, for different products - [ ] Yes, across international subsidiaries - [x] No, consistency must be maintained - [ ] Yes, but only if audited > **Explanation:** Generally, companies must maintain consistent application of inventory valuation methods, using either FIFO or LIFO but not both simultaneously for the same type of inventory. ### FIFO is typically chosen by companies to... - [x] Reflect actual physical inventory flow - [ ] Minimize taxes - [ ] Simplify bookkeeping - [ ] Predict future costs > **Explanation:** FIFO is chosen to reflect the true physical flow of inventories where older items are sold first, ensuring accurate and realistic financial reporting. ### An essential attribute of FIFO is that... - [x] Inventory contains most recently purchased items - [ ] Inventory contains least recently purchased items - [ ] It requires complex calculations - [ ] It minimizes profit > **Explanation:** FIFO ensures that the inventory contains the most recently purchased items, with the oldest costs moved to COGS.

Thank you for exploring the concept of FIFO and engaging with our quiz questions. This knowledge will help you understand the impact of different inventory valuation methods on financial statements!

First In, First Out (FIFO)

Definition