How does FIFO impact inventory accounting?

FIFO, or First-In, First-Out, is an inventory valuation method that assumes that the oldest inventory items are sold first. This fundamental principle influences the cost of goods sold (COGS) and ending inventory on the financial statements.

When using FIFO, the cost of the oldest inventory is recognized in COGS when the items are sold. This can be particularly impactful in times of inflation. If prices are rising, the oldest, cheaper items will contribute to COGS, potentially resulting in higher profits on paper because the newer, more expensive items remain in inventory. Therefore, FIFO generally creates a scenario where the profit figures appear healthier in the short term compared to other inventory valuation methods.

This method affects how profits are reported, particularly during financial analysis. By assuming the oldest costs are matched against current revenues, FIFO can lead to inflated profit margins when commodity prices are rising. Understanding this mechanism is crucial for businesses, as it affects not only profit reporting but also tax liabilities and financial planning.