What is First-In First-Out (FIFO)?
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 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. In addition, 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 a cost of $700.
- 50 units at $4/unit = $200 in inventory
- 100 units at $5/unit = $500 in inventory
FIFO vs. LIFO
Consider the same example above. Recall that under First-In First-Out we had the following cost flows for the sale of 250 units:
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 financial statements for COGS and inventory depend on the inventory valuation method used. 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 another inventory valuation method – LIFO. The two methods yield different inventory and COGS. Now it is important to consider – what impact does using FIFO make on a company’s financial statements?
1. High quality of balance sheet valuation
By using FIFO, the balance sheet shows higher quality information about inventory. It does not affect the most recent purchases, thus providing high-quality information about the valuation of inventory.
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, as the cost of the newer snowmobile shows a greater resemblance to the current value.
2. Low quality of income statement matching
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 at a price of $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 cost of goods purchased first (first-in) is first to be expensed (first-out).
- It provides a higher quality of balance sheet valuation, as compared to the LIFO inventory system.
- It provides a low quality of income statement matching.
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