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.
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.
Conversely, this method also results in older historical purchase price allocated to the cost of goods sold (COGS) and matched against current period revenues.
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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 Principles (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:
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.
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.
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 view 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).
Advantages
- FIFO method of accounting saves time, and money spends in calculating the exact inventory cost that is being sold because the recording of inventory is done in the same order as they are purchased or produced.
- Easy to understand.
- Ending inventory is valued based on the most recent purchase price; therefore, inventory value is a much better reflection of current market prices of similar products.
- As the oldest available units are used for the cost of goods sold calculation, possible risk of reduced net realizable value (NRV) and resulting loss recognition is negated as an entity is not dragging any old inventory units in records.
- As the closing stock value is critical in current asset calculation and related accounting ratios (for example, liquidity ratios), therefore, the FIFO method of inventory valuation is much relevant to value ending inventory.
- Normally in an inflationary environment, prices are always rising, which will cause an increase in operating expenses, but with FIFO accounting, the same inflation will cause an increase in ending inventory value that will help increase gross profit and ultimately covering other inflated operating expenses.
Disadvantages
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
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