Firms have a choice among FIFO, LIFO or the average-cost method for valuing inventories. Depending on the chosen method, costs associated with inventory sold will differ, as will the reported asset values of remaining inventory. The First In, First Out (FIFO) method holds that the first items purchased by the company (the oldest inventory) are the first items sold. In a period of rising prices this results in lower costs of goods sold and higher net income.
The Benefits and Drawbacks to Using FIFO
Using FIFO results in the firm being left with the most recent inventory purchases. This is an advantage of using FIFO in that it is the most accurate representation of inventory replacement costs. It also, however, overstates net income. When prices are rising, matching old, cheaper inventory with current sales will underestimate costs, boosting income.
Differences in Accounting Standards Between The U.S. and Europe
European companies are required to use FIFO for tax reporting purposes because using LIFO would result in lower net income, and hence, lower taxes. American companies may use different valuation methods for financial reporting and tax reporting.
FIFO in a Deflationary Environment
In a period where prices are falling, FIFO will result in higher cost of good sold and lower net income, because older, higher inventory costs are being paired with current sales.