FIFO- Definition, Purpose and examples

FIFO stands for First In, First Out.

First In, First Out, or FIFO as it is more commonly known, is an asset management and valuation technique wherein assets that are produced or acquired first are sold, used, or disposed of first.

For taxation purposes, the cost of goods sold (COGS) on the income statement is presumed to include assets with the oldest costs. The remaining inventory assets are compared to the ones that were made or bought most recently.

KEY LESSONS.

1. First In, First Out (FIFO) is an accounting principle that states that assets that are bought or acquired first are also sold first.

2. According to FIFO, the stock that is still available is made up of items that were bought last.

3. A different accounting practice from FIFO is LIFO, which requires that assets that were acquired or purchased most recently be sold first.

4. The FIFO method frequently produces higher net income than the LIFO method in an inflationary market because lower, older costs are assigned to the cost of goods sold.

FIFO: First In, First Out: Understanding

To make cost flow assumptions, the FIFO method is employed. The associated costs with a product must be recorded as an expense in manufacturing as it advances to later stages of development and as finished inventory items are sold.

In accordance with FIFO, it is anticipated that the cost of inventory acquired first will be recorded first. Because inventory has been taken out of the company's ownership during this process, the total dollar value of inventory declines. The FIFO method is one of many methods that can be used to determine the costs related to the inventory.

Common economic circumstances include price increases and market inflation. The oldest costs in this scenario would theoretically be priced lower than the most recent inventory bought at the current inflated prices if FIFO assigned the oldest costs to the cost of goods sold.

Higher net income is the result of the lower cost. The ending inventory balance is also inflated because the most recent inventory was bought at generally higher prices.

Companies are free to select the method of valuation they want to employ. Even though their choice has financial repercussions, some businesses might opt for a technique that replicates their inventory (i. E. It's common practice for a grocer to sell the oldest stock first.

An illustration of FIFO

As products are prepared for sale, inventory is given costs. This can happen by investing in inventory or paying for production costs, purchasing supplies, and hiring workers. These allocated costs are based on the order in which the product was used, and for FIFO, it is based on what arrived first.

Consider a scenario where a business bought 100 items for $10 each, then 100 more items for $15 each. The business then sold 60 items. The 60 items would each have a cost of goods sold of $10 per unit under the FIFO method since the first item bought would also be the first item sold. Of the 140 items still in stock, 40 are worth $10 per unit and 100 are worth $15 per unit. This is so because the FIFO method gives inventory the most recent cost.

Let's say the business sells an additional 50 items out of the 140 units of inventory that are still available. 40 of these items have a cost of goods sold of $10 each, and the initial 100-unit order has been completely filled. The remaining 90 units in inventory are valued at $15 each (the most recent price paid), while the remaining 10 units that were sold cost $15 each.

According to the FIFO method, a business should sell its oldest inventory items first and keep its newest ones on hand in order to prevent obsolescence. An entity must be able to explain why it chose to use a specific inventory valuation method, even though the actual method used does not have to correspond to the actual flow of inventory through a company.

FIFO vs. LIFO

The LIFO inventory valuation method, which places the most recent item acquired or purchased as the first item out, is the opposite of FIFO. When compared to FIFO, this has the effect of deflating net income costs and lowering ending inventory balances in inflationary economies.

FIFO and LIFO are diametrically opposed in many ways. A business sells the last item in its inventory rather than the first. As a result, the inventory item sold under LIFO is charged a higher cost of goods sold during periods of rising prices. Because of this, a company's expenses are typically higher under these circumstances, which means that net income under LIFO is lower than it would be under FIFO during periods of inflation.

These two valuation techniques also have effects on balance sheets. Due to the fact that more expensive inventory items are frequently sold under LIFO, FIFO is used to maintain these more expensive inventory items as inventory on the balance sheet. Under FIFO, net income is frequently higher, but inventory is frequently bigger as well.

International Financial Reporting Standards do not permit LIFO.

FIFO vs. Other Valuation Methods

Average Cost Inventory

Each item's cost is the same when using the average cost inventory method. The average cost method is calculated by dividing the total number of items that are available for sale by the cost of goods in inventory. As a result, there is net income as well as FIFO and LIFO ending inventory balances.

Tracing particular inventory

When every component linked to a finished good is known, specific inventory tracing is then employed. The use of FIFO, LIFO, or average cost is appropriate if all the pieces are not known.

The benefits and drawbacks of FIFO.

Because the FIFO method is simple to comprehend and apply, many businesses prefer it. As a result, financial statements are more comprehensible and it is more difficult to use FIFO-based accounting to inflate a company's earnings. Due to this, FIFO is both a standard practice in many other jurisdictions and a requirement under the International Financial Reporting Standards in some of them.

Additionally, since the oldest products are the ones that are most likely to lose value from long-term storage, most businesses prefer to sell those first. This method also reflects the natural flow of inventory. Since the products that are still unsold are also the newest ones, this also means that the company's financial statements will more accurately reflect the value of current inventory.

Certain drawbacks do exist, though. Due to the wider difference between costs and revenue under the FIFO method, the company may have to pay higher income taxes. Additionally, the company's profits may be overstated as a result of this.