FIFO Inventory Method

What is FIFO Inventory Valuation Method?

FIFO accounting method stands for First In First Out and is one of the most common methods to value inventory at the end of any accounting period, and thus it impacts the cost of goods sold value during the particular period.

Inventory costs are reported either on the balance sheet, or they are transferred to the income statement as an expense to match against sales revenue. When inventories are used up in production or are sold, their cost is transferred from the balance sheet to the income statement as cost of goods sold.

Base Equation FIFO

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Under the FIFO method of accounting inventory valuation, the goods which are purchased at the earliest are the first one to be removed from the inventory account. This results in remaining inventory at books to be valued at the most recent price for which the last stock of inventory is purchased. This results in inventory assets recorded on the balance sheet at the most recent costs.

first in first out Inventory

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Conversely, this method also results in older historical purchase price allocated to the cost of goods sold (COGS) and matched against current period revenues.

FIFO method of inventory valuation results in an overstatement of gross margin in an inflationary environment and therefore does not necessarily reflect a proper matching of revenues and costs. For example, in an environment where inflation is on the upward trend, current revenue will be matched against older and lower-cost inventory items, and this will result in the highest possible gross margin.

The FIFO method inventory valuation is commonly used under both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting PrinciplesGenerally Accepted Accounting PrinciplesGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors.read more (GAAP).

First In First Out Inventory Method Examples

ABC Corporation uses the FIFO method of inventory valuation for the month of December. During that month, it records the following transactions:

Example of the first in first out Method

Unit of Goods sold: 1000 Beginning inventory + 2000 Purchased – 1250 Ending inventory = 1750 Units. Calculation of First In First Out method

The controller uses the information in the above table to calculate the cost of goods sold for the month of December, as well as inventory balance as of the end of December.

Example of the first in first out Method 1

As shown above, $42,000 cost of goods sold and $36,000 ending inventory equals the $78,000 combined total of beginning inventory and purchases during the month.

first in first out example Balance Sheet

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Reason for Using FIFO Method of Inventory Valuation

A business which is in the trading of perishable items generally sells the items which are purchased earliest first, FIFO method of inventory valuation generally gives the most accurate calculation of the inventory and sales profit. Other examples include retail businesses that sell foods or other products with an expiration date.

However, there are times when even other businesses that don’t fit this description of perishable items use First In First Out method for the following reason: Profit and loss statement would reflect a higher gross profit and shows a stronger financial position that is higher net profit to the investors. From the balance sheet point of viewBalance Sheet Point Of ViewA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more also, the inventory is valued at a cost at the current price, and this would results in a strong balance sheet as inventory would potentially carry a higher value under the FIFO method inventory valuation (assuming an inflationary environment).

First in First Out FIFO

Advantages

Disadvantages

First in First Out FIFO - BP Example

source: bp.com

  • One of the biggest disadvantages of FIFO accounting method is inventory valuation during inflation, First In First Out method will result in higher profits, and thus will results in higher “Tax Liabilities” in that particular period. This may result in increased tax charges and higher tax-related cash outflows.
  • Use of First In First Out method is not a suitable measure of inventory in times of “hyperinflation.” During such times, there is no particular pattern of inflation, which may result in prices of goods to inflate drastically. Thus in such periods, the matching of most prior purchases with most recent sales would not be appropriate and present a distorted picture as the profit may be pumped up.
  • FIFO method of inventory valuation is not an appropriate measure if the goods/materials purchased have fluctuation in their price patterns as this may results in misstated profits for the same period.
  • Although the FIFO inventory valuation method is easy to understand, it may get cumbersome and clumsy to extract and operate the costs of goods, as a substantial amount of data is required, which may result in clerical errors.

Video on FIFO Inventory Method

 

This has been a guide to FIFO Inventory Methods. We discuss first in first out accounting along with practical examples. Here we also look at the advantages and disadvantages of using FIFO accounting on inventory valuations. You may also have a look at these articles below to learn more on accounting –

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