FIFO

FIFO tracks costs, not physical units. Each time goods are sold, the accountant removes the oldest unit cost still sitting in the inventory pool and transfers it to cost of goods sold; whatever remains in the pool is the most recently purchased layers, valued at the prices paid nearest the balance sheet date. Ending inventory is therefore computed by pricing the units on hand from the latest purchase backwards until the physical count is exhausted, and cost of goods sold equals beginning inventory plus purchases minus that ending inventory figure.

A useful property is that FIFO produces identical results whether the firm uses a periodic or a perpetual system, because the sequence in which the oldest layers are released does not depend on when the calculation is performed. Weighted average cost and LIFO do not share this feature.

When input prices rise, the layers released to cost of goods sold are stale and relatively cheap, so gross profit, operating income, pre-tax income and tax expense are all higher than they would be under LIFO, while ending inventory sits close to replacement cost. The balance sheet is the more economically current of the two statements; the income statement is the less current. When prices fall, every one of these relationships reverses.

Ratios shift accordingly. Higher inventory and higher retained earnings lift the current ratio, working capital and total equity, which depresses debt-to-equity and return on equity. Inventory turnover is lower under FIFO than LIFO in an inflationary setting, because the numerator carries older costs while the denominator carries newer ones, so days of inventory on hand looks longer.

IFRS reporters must use FIFO or weighted average cost, so FIFO dominates outside the United States. US filers may choose LIFO, and those that do disclose a LIFO reserve, the cumulative difference between LIFO inventory and what inventory would be on a FIFO or current-cost basis. Analysts restate the LIFO firm onto a FIFO basis by adding the reserve to inventory, adding the after-tax reserve to equity, recognising the balance of the reserve as a deferred tax liability, and reducing cost of goods sold by the increase in the reserve during the period.

Measurement rules also differ by method. Inventory carried at FIFO is written down to net realisable value when cost exceeds it, and under IFRS a subsequent recovery in value may be reversed up to the original cost, whereas US GAAP prohibits the reversal.

Be able to compute cost of goods sold and ending inventory from a schedule of purchases at different prices, and to state without hesitation which direction each line item moves relative to LIFO and weighted average under rising or falling costs. Weighted average always falls between the two extremes.

Be equally comfortable running the LIFO-to-FIFO conversion in both directions and tracing its consequences: the effect on the current ratio, on inventory turnover, on the effective tax rate, and on the quality of reported earnings. Recognise too that a FIFO reporter cannot generate the artificial margin boost of a LIFO liquidation, which makes FIFO gross margins easier to interpret across periods, and that the tax advantage LIFO enjoys in the United States when prices rise is precisely the cash flow benefit a FIFO reporter forgoes.