What Accounting Method Prices Oldest Stocks First?

Understanding the First-In, First-Out (FIFO) Method

Inventory valuation methods determine how a business accounts for the cost of goods it sells and the value of inventory remaining on hand. The First-In, First-Out (FIFO) method assumes that the first items purchased or produced are the first ones sold. This method aligns with the natural flow of many businesses, where older inventory is typically moved before newer stock to prevent obsolescence or spoilage. When a sale occurs, the Cost of Goods Sold (COGS) is derived from the oldest inventory units available. This means the specific costs of the first items purchased are expensed first, regardless of whether those exact physical items were sold.

Consider a small bakery that purchases flour in batches. If the bakery buys 100 pounds of flour at $1.00 per pound on Monday and another 100 pounds at $1.20 per pound on Wednesday, and then sells 150 pounds of flour on Friday, FIFO assumes the first 100 pounds sold came from Monday’s purchase. The remaining 50 pounds sold would be attributed to Wednesday’s purchase.

COGS under FIFO is calculated by summing the costs of the earliest units sold until the total quantity sold is accounted for. In the bakery example, the COGS for the 150 pounds of flour would be (100 pounds $1.00) + (50 pounds $1.20), totaling $160.

Conversely, the value of the ending inventory remaining on the balance sheet under FIFO is comprised of the costs of the most recently purchased goods. Following the bakery example, if 50 pounds of flour remain after the sale, these 50 pounds are assumed to be from the Wednesday purchase costing $1.20 per pound. Therefore, the ending inventory would be valued at $60 (50 pounds $1.20), reflecting the most recent acquisition costs.

How FIFO Affects Financial Reporting

The application of the First-In, First-Out (FIFO) method directly influences a company’s financial statements, notably the income statement and the balance sheet. During periods when inventory costs are generally rising, a common scenario in an inflationary environment, FIFO typically results in a lower Cost of Goods Sold (COGS). This occurs because the oldest, and thus generally lower, costs are matched against current sales revenue.

A lower COGS, in turn, leads to a higher reported gross profit on the income statement. This higher gross profit flows down to result in a higher net income for the period. Consequently, a higher net income often translates to a higher taxable income, which can mean a greater income tax liability for the business.

Conversely, in periods of falling inventory costs, FIFO’s impact reverses. The COGS will be higher because the older, more expensive inventory costs are expensed first. This results in a lower reported gross profit and, subsequently, a lower net income. A reduced net income would then lead to a lower taxable income and, therefore, a potentially smaller income tax payment.

Regarding the balance sheet, FIFO’s effect on ending inventory valuation is significant. In an environment of rising prices, the ending inventory reported on the balance sheet under FIFO will consist of the most recently acquired units. These units typically have higher costs, leading to a higher reported inventory value on the balance sheet. This higher valuation can present a more current and realistic representation of the inventory’s replacement cost.

When prices are declining, the ending inventory under FIFO will still reflect the most recent costs, which would now be lower. This results in a lower reported inventory value on the balance sheet.

When FIFO is Commonly Applied

The First-In, First-Out (FIFO) method finds common application in businesses that manage perishable goods or products with a limited shelf life. Industries dealing with food products, pharmaceuticals, or certain fashion items often adopt FIFO because it naturally aligns with the physical flow of their inventory, where older stock must be sold before it expires or becomes outdated. This approach helps minimize spoilage and obsolescence, ensuring product freshness and quality for consumers.

Businesses with high inventory turnover also frequently utilize FIFO, as it simplifies the tracking of costs when goods move quickly through the system. For instance, a retail store selling electronics might use FIFO because newer models frequently replace older ones, and the cost assumption aligns with the need to clear out older inventory first.

Furthermore, FIFO is widely adopted because it generally presents a more accurate picture of the current value of inventory on the balance sheet. In an inflationary environment, where prices are rising, FIFO ensures that the ending inventory is valued at more recent, typically higher, costs. This provides stakeholders with a balance sheet that better reflects the current economic value of the assets held by the company. The method’s ability to mirror the actual physical flow of goods, combined with its tendency to report inventory at values closer to current replacement costs, makes it a preferred choice for many companies seeking transparent financial reporting.