What Are the FIFO Disadvantages in Accounting?

FIFO (First-In, First-Out) is a widely used inventory valuation method that assumes the oldest stock is sold first. While it simplifies accounting and aligns with the natural flow of goods, it also has drawbacks that affect financial reporting and tax obligations. Businesses must consider these disadvantages when determining their inventory strategy.

Inflated Tax Liabilities in Rising Price Environments

When costs rise, FIFO records older, lower-cost inventory as the cost of goods sold (COGS), while newer, higher-cost inventory remains on the balance sheet. This increases reported profits since expenses appear lower than they would under methods like LIFO (Last-In, First-Out). While higher profits may seem beneficial, they also lead to greater taxable income, raising a company’s tax burden.

For companies in jurisdictions with progressive tax systems, this can push them into higher tax brackets. In the U.S., corporate tax rates are a flat 21% as of 2024, but state taxes vary, with some states like New Jersey imposing rates up to 11.5%. A company that reports an additional $1 million in taxable income due to FIFO could owe an extra $210,000 in federal taxes alone, not including state obligations.

Industries with fluctuating input costs, such as manufacturing and retail, are particularly affected. If a retailer buys inventory at $50 per unit but later purchases the same goods at $70 due to rising costs, FIFO still records the $50 cost when those units are sold. This inflates gross profit margins, making financial statements appear stronger than they actually are. Investors and lenders may misinterpret these figures, leading to unrealistic expectations about future performance.

Less Accurate Margins During Downward Cost Trends

When inventory costs decline, FIFO assigns older, higher-cost inventory to COGS while newer, lower-cost inventory remains on the balance sheet. This results in inflated expenses, reducing reported gross margins and net income. Companies may appear less profitable than they actually are, which can mislead investors and creditors evaluating financial health.

This issue is especially noticeable in industries with frequent price drops, such as technology and consumer electronics. If a company buys microchips at $15 per unit but later acquires them for $10, FIFO continues to record the $15 cost until older inventory is depleted. This artificially lowers profit margins, potentially affecting stock valuation and investor confidence. Businesses reliant on external financing may struggle to secure favorable loan terms if financial statements suggest weaker profitability than actual cash flows indicate.

Accounting ratios like gross margin and return on assets (ROA) can also be distorted. A company using FIFO in a deflationary environment may report a lower gross margin percentage than competitors using different valuation methods. This can create a misleading perception of inefficiency, prompting investors to favor companies that appear to have better cost management.

Potential Mismatch for Global Supply Chains

Companies operating in multiple countries face challenges when applying FIFO, as currency fluctuations and regional cost differences can distort financial reporting. A business sourcing raw materials from both the U.S. and China may purchase identical goods at different prices due to exchange rate shifts and local economic conditions. FIFO assumes the oldest inventory is sold first, but if that inventory was acquired when the U.S. dollar was weaker, costs may appear artificially high when converted back into financial statements. This can lead to inconsistencies in profitability across regions, complicating performance comparisons and strategic decision-making.

Regulatory differences add another layer of complexity. While International Financial Reporting Standards (IFRS) permit FIFO, some jurisdictions impose additional compliance requirements that can create discrepancies in consolidated financial statements. A multinational company with subsidiaries in both the U.S. and Germany may face challenges aligning its inventory accounting under Generally Accepted Accounting Principles (GAAP) versus IFRS. These differences can affect reported earnings, tax liabilities, and transfer pricing strategies, requiring careful coordination to ensure compliance and avoid penalties.

Complex Recordkeeping for Varied Inventory Costs

Managing inventory under FIFO requires detailed tracking, especially for businesses dealing with diverse product lines, seasonal goods, or perishable items. As inventory ages, companies must maintain accurate records to ensure proper cost allocation. This becomes more difficult when suppliers offer bulk discounts, promotional pricing, or fluctuating shipping fees. A retailer purchasing goods at different price points throughout the year must track purchase dates and costs carefully to apply FIFO correctly, increasing administrative complexity and the risk of misstatements.

Industries with high inventory turnover, such as pharmaceuticals and food distribution, face additional challenges. Expiration dates often dictate sales order fulfillment, which may not align with FIFO’s assumption that the oldest costs should be recognized first. Pharmaceutical companies, for instance, may prioritize selling newer batches with longer shelf lives to avoid waste, creating discrepancies between physical inventory flow and accounting records. This misalignment can lead to audit complications, requiring extensive reconciliation efforts to verify compliance with financial reporting standards.