First In, First Out

Core Description

• First In, First Out (FIFO) is a foundational inventory valuation method widely used across industries due to its simplicity and transparency.
• FIFO aligns accounting with real-world asset flows, enhancing financial statement clarity, auditability, and cross-period consistency.
• Understanding FIFO’s mechanics, advantages, and limitations is crucial for investors, accountants, and managers seeking accurate cost control and compliance.

Definition and Background

What is FIFO?
First In, First Out (FIFO) is an inventory cost flow assumption where the earliest acquired or produced goods are considered sold or used first. This method assigns the cost of the oldest inventory items to the cost of goods sold (COGS), and the cost of more recently acquired inventory to ending inventory on the balance sheet.

Historical Roots

FIFO’s conceptual origins can be traced to ancient storage practices, such as Greco-Roman and medieval guild storerooms that distributed older goods first to prevent spoilage. The Industrial Revolution and the onset of mass production led to the formalization of FIFO, with companies implementing bin cards and documented ticket systems to track lots, supporting freshness, quality, and efficient warehouse management.

Evolution in Accounting

Through the late 19th and early 20th centuries, accounting thought began to differentiate inventory flow assumptions. Authors such as Paton and Littleton reinforced FIFO’s legitimacy as a cost-matching convention, which proved particularly useful for businesses operating in inflationary environments. The method gained further prominence with regulators and auditors, thanks to its logical alignment with physical stock movements and its support for transparent, consistent reporting.

Regulatory Environment

International accounting standards such as IFRS explicitly allow FIFO (while banning Last In, First Out, or LIFO), and U.S. GAAP permits FIFO alongside LIFO and weighted average. As companies globalized, FIFO’s acceptance under IFRS made it the default for many cross-border and multinational entities, facilitating financial comparability and streamlining audit and compliance processes.

Key Point:
FIFO does not necessitate the physical first-out of inventory. It is an accounting convention that organizes and values inventory transactions chronologically.

Calculation Methods and Applications

FIFO Mechanics

FIFO maintains layers of inventory based on purchase or production dates. When a sale occurs, inventory is relieved starting from the oldest available lot until the order is fulfilled.

Example Calculation (Hypothetical Case):

An electronics retailer purchases 100 units at $10 each, then 100 more at $12. They sell 150 units. Under FIFO:

• 100 units from first batch: 100 × $10 = $1,000
• 50 units from second batch: 50 × $12 = $600
• Total COGS: $1,600
• Ending inventory: Remaining 50 units @ $12 = $600

Formulas

• COGS (per period): FIFO COGS = Sum over each sale: (units from oldest layers × unit cost), moving chronologically through layers.
• Ending Inventory: Sum the remaining units in each unconsumed layer × that layer’s cost.

Periodic vs. Perpetual FIFO

• Perpetual FIFO: Updates inventory with every transaction, generating real-time COGS.
• Periodic FIFO: Calculates COGS and ending inventory at period end, aligning costs and quantities in aggregate.

Treatment of Returns, Discounts, and Shrinkage

• Returns: Attempt to assign returned items back to the original FIFO layer. If untraceable, allocate to the oldest open layer.
• Purchase discounts: Reduce the cost of specific layers.
• Shrinkage: Remove quantities from oldest layers to maintain accurate COGS and inventory value.

Foreign Currency Transactions

Purchased inventory in foreign currencies is translated at the spot rate on the acquisition date. These layers are not retranslated, but foreign exchange gains or losses may be recorded separately, according to accounting policy.

Layer Reconciliation and Internal Controls

Essential controls include reconciling opening inventory, purchases, COGS, and ending inventory. Regular audits and cycle counts are critical to maintaining FIFO integrity.

Comparison, Advantages, and Common Misconceptions

FIFO vs LIFO vs Weighted Average

• FIFO: Assigns oldest costs to COGS, resulting in newer costs in ending inventory.
• LIFO: Assigns most recent costs to COGS, leaving older costs in inventory (banned under IFRS).
• Weighted Average: Blends all costs together for a period, smoothing out price fluctuations.

Key Advantages

• Transparency: FIFO allows clear traceability of margins and lot-level auditability.
• Balance Sheet Relevance: Ending inventory reflects recent, realistic replacement costs.
• Global Acceptance: Supported under both IFRS and US GAAP, facilitating multinational reporting.

Limitations

• Tax Impact: During inflation, FIFO reports higher profits, which increases taxable income.
• Potential Mismatches: If physical movement differs substantially from FIFO order, accounting may not reflect actual operations.
• Reduced Flexibility: Less ability to manage taxable income than with LIFO (where permitted).

Common Misconceptions

• FIFO always mirrors physical flow: This is not necessarily true; actual warehouse logistics may differ.
• FIFO always produces the lowest taxes: Incorrect, as LIFO can defer taxes during inflation where allowed.
• Easy to mix FIFO with other methods: Mixing methods within the same pool is not allowed and creates inconsistencies.

Practical Guide

Policy Setup

• Document Scope: Clearly outline which inventory types, locations, and valuations will use FIFO.
• Set Controls: Label receipts by date, use barcodes or RFID, and configure ERP/WMS for FIFO enforcement.
• Train Staff: Regularly train employees and audit procedures for compliance.

Systems and Automation

Modern ERP/WMS systems (such as SAP, Oracle, Microsoft Dynamics) can fully automate FIFO layer tracking, pick-paths, expiry monitoring, and exception approvals, reducing manual errors.

Reconciliation and Auditing

Conduct regular cycle counts, reconcile physical and book inventories, and investigate negative or stagnant lots.

Handling Special Situations

• Returns: Assign returns back to the originating layer to keep margins accurate.
• Shrinkage/Write-downs: Record losses against oldest layers to avoid inventory overstatement.

Case Study (Hypothetical Example)

A U.S. supermarket chain adopted FIFO for its dairy segment to minimize spoilage and audit issues. By configuring their WMS to enforce FIFO pick rules for milk and high-turn dairy items, they reduced annual write-offs by 15 percent and improved gross margin clarity for management reporting.

Portfolio Accounting

Investment platforms may use FIFO by default for tax-lot selection unless an alternate election is made. This affects reporting of realized gains, capital gains taxes, and holding periods. Reconcile fills and statements regularly to ensure tax compliance.

Change Management

Transitioning from LIFO or average cost requires reconstructing past layers, staff training, and possibly retrospective adjustment and financial statement restatement.

Resources for Learning and Improvement

• Accounting Standards:

  • IAS 2 Inventories (IFRS)
  • ASC 330 (US GAAP)
  • IASB Standards Navigator and FASB Codification

• Tax Guidance:

  • IRS Publication 538, Topic 701
  • HMRC’s Business Income Manual
  • U.S. Treasury & SEC tax rules

• Auditing Standards:

  • ISA 501, ISA 330
  • PCAOB AS 2510, AU‑C 501

• Key Textbooks:

  • "Intermediate Accounting" by Kieso, Weygandt & Warfield
  • "Cost Accounting" by Horngren
  • "Financial Statement Analysis" by Penman

• Professional Insights:

  • AICPA, ACCA, CIMA—technical guides and exam prep
  • Big Four practice sites: Deloitte, PwC, EY, KPMG

• ERP Vendor Documentation:

  • SAP S/4HANA, Oracle NetSuite, Microsoft Dynamics user guides

• Education and Investor Resources:

  • Coursera, edX MOOCs on accounting/inventory
  • IFRS Foundation webinars
  • Investor.gov tutorials

FAQs

What is FIFO?

FIFO is an inventory and tax-lot valuation method where the oldest goods purchased or produced are assumed to be sold or used first, impacting both COGS and ending inventory values.

How does FIFO affect COGS and margins?

During inflationary periods, FIFO results in lower COGS and higher gross margins because historical, lower costs are expensed first. In deflation or when input prices drop, the pattern reverses.

How does FIFO perform under inflation and deflation?

Under inflation, FIFO increases reported profits and taxes due to lower COGS, but inventory values better reflect current market conditions. During deflation, it can depress margins as higher-cost layers flow into COGS.

Is FIFO allowed under IFRS and US GAAP?

FIFO is permitted under both IFRS and US GAAP, though IFRS prohibits LIFO while US GAAP allows it alongside FIFO and average cost methods.

How is FIFO applied to securities?

In portfolio accounting, FIFO assumes the earliest acquired securities are sold first, impacting gain/loss recognition, taxable events, and holding periods.

Can a company switch to (or from) FIFO?

Changes in inventory accounting methods require regulatory compliance, retrospective adjustment, and disclosure to ensure comparability in financial statements.

What are common implementation pitfalls?

Common issues include mismatched physical/cost flows, incomplete cost allocation (such as missing freight-in), inaccurate layer tracking, and system misconfigurations.

Conclusion

First In, First Out (FIFO) remains an important method in contemporary inventory and asset management, offering a clear and consistently auditable approach for aligning accounting with operational flows. Its straightforward logic supports compliance and enhances the relevance of financial statements, and it is broadly accepted under major accounting standards. Practitioners need to thoroughly understand calculation methods, regulatory requirements, and the effects of inflation or deflation on reported profits and taxes. Implementing robust controls, leveraging automation, and staying updated on evolving standards can help companies and investors benefit from FIFO’s strengths while avoiding common issues—ensuring inventory reporting that is transparent, comparable, and reliable.