The First-in First-out (FIFO) method of inventory valuation is based on the assumption that the sale or usage of goods follows the same order in which they are bought. In other words, under the first-in, first-out method, the earliest purchased or produced goods are sold/removed and expensed first. Therefore, the most recent costs remain on the balance sheet, while the oldest costs are expensed first. FIFO is also called last-in-still-here (LISH).
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Example of First-In, First-Out (FIFO)
Company A reported beginning inventories of 100 units at $2/unit. Also, the company made purchases of:
100 units @ $3/unit
100 units @ $4/unit
100 units @ $5/unit
If the company sold 250 units, the order of cost expenses would be as follows:
As illustrated above, the cost of goods sold (COGS) is determined with beginning inventories and moves its way downwards (to more recent purchases) until the required number of units sold is fulfilled. For the sale of 250 units:
100 units at $2/unit = $200 in COGS
100 units at $3/unit = $300 in COGS
50 units at $4/unit = $200 in COGS
The total cost of goods sold for the sale of 250 units would be $700.
The remaining unsold 150 would remain on the balance sheet as inventory at the cost of $700.
Consider the same example above. Recall that under First-In First-Out, the following cost flows for the sale of 250 units are given below:
Compare this to the LIFO method of inventory valuation, which expenses the most recent inventories first:
Under LIFO, the sale of 250 units:
100 units at $5/unit = $500 in COGS
100 units at $4/unit = $400 in COGS
50 units at $3/unit = $150 in COGS
The company would report a cost of goods sold of $1,050 and inventory of $350.
COGS = $700
Inventory = $700
COGS = $1,050
Inventory = $350
Therefore, we can see that the balances for COGS and inventory depend on the inventory valuation method. For income tax purposes in Canada, companies are not permitted to use LIFO. However, US companies are able to use FIFO or LIFO. As we will discuss below, the FIFO method creates several implications on a company’s financial statements.
Impact of FIFO Inventory Valuation Method on Financial Statements
Recall the comparison example of First-In First-Out and LIFO. The two methods yield different inventory and COGS. Now it is important to consider the impact of using FIFO on a company’s financial statements?
1. Better valuation of inventory
By using FIFO, the balance sheet shows a better approximation of the market value of inventory. The latest costs for manufacturing or acquiring the inventory are reflected in inventory, and therefore, the balance sheet reflects the approximate current market value.
For example, consider a company with a beginning inventory of two snowmobiles at a unit cost of $50,000. The company purchases another snowmobile for a price of $75,000. For the sale of one snowmobile, the company will expense the cost of the older snowmobile – $50,000.
Therefore, it will provide higher-quality information on the balance sheet compared to other inventory valuation methods. The cost of the newer snowmobile shows a better approximation to the current market value.
2. Poor matching of revenue with expense
Since First-In First-Out expenses the oldest costs (from the beginning of inventory), there is poor matching on the income statement. The revenue from the sale of inventory is matched with an outdated cost.
For example, consider the same example above with two snowmobiles at a unit cost of $50,000 and a new purchase for a snowmobile for $75,000. The sale of one snowmobile would result in the expense of $50,000 (FIFO method). Therefore, it results in poor matching on the income statement as the revenue generated from the sale is matched with an older, outdated cost.
Key Takeaways from First-in First-Out (FIFO)
FIFO expenses the oldest costs first. In other words, the inventory purchased first (first-in) is first to be expensed (first-out) to the cost of goods sold.
It provides a better valuation of inventory on the balance sheet, as compared to the LIFO inventory system.
It provides a poor matching of revenue with expenses.
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