FSA
Understanding FIFO (First-In, First-Out)
FIFO is an inventory valuation method based on a simple assumption: the earliest purchased inventory is sold first. In many businesses, this assumption closely matches the actual physical flow of goods, which is why FIFO feels intuitive and widely accepted.
FIFO is frequently tested because it affects inventory valuation, profitability, financial ratios, and comparability across firms.
What FIFO Really Means
Under FIFO, the oldest inventory costs are treated as the first units sold.
This means:
- earlier purchase costs flow into cost of goods sold
- recent purchases remain in ending inventory
As prices change over time, this cost flow assumption has a direct impact on reported profits and balance sheet values.
FIFO in a Rising Price Environment
FIFO becomes especially relevant when prices are rising.
Older inventory usually costs less.
These lower costs move into the cost of goods sold.
Reported profits tend to be higher.
Higher profits often result in higher tax payments. This trade-off between reported income and taxes is a common exam focus.
Impact of FIFO on Financial Statements
FIFO affects both major financial statements.
On the income statement:
- lower cost of goods sold (in rising prices)
- higher gross profit and net income
On the balance sheet:
- inventory reflects more recent costs
- inventory values are closer to current market prices
Understanding this dual impact is essential for analysis questions.
FIFO vs LIFO
This comparison appears frequently in exams.
FIFO results in:
- lower cost of goods sold (when prices rise)
- higher reported income
- higher ending inventory
LIFO results in:
- higher cost of goods sold
- lower reported income
- lower ending inventory
Candidates are often tested on how these differences affect ratios and cash flows.
FIFO and Cash Flows
FIFO does not directly change cash flows from operations, but it affects taxes.
Higher reported income leads to higher tax payments.
This reduces operating cash flow compared with LIFO in inflationary periods.
Understanding this distinction helps avoid confusing accounting profit with cash generation.
FIFO and Financial Ratios
FIFO generally results in:
- higher current ratios
- higher inventory turnover denominator values
- stronger profitability ratios
However, these improvements reflect accounting treatment rather than operational efficiency. Exams often test this nuance.
FIFO Under Accounting Standards
FIFO is:
- permitted under IFRS
- permitted under US GAAP
This makes FIFO the most globally comparable inventory valuation method.
Common Student Misunderstandings
Many students assume FIFO always shows better performance. It does not.
Some forget that FIFO benefits profitability mainly during rising prices.
Others ignore tax implications entirely.
Exams often test these misunderstandings indirectly.
Final Thought
FIFO is simple in concept but powerful in impact. It influences reported profits, inventory values, taxes, and financial ratios without changing underlying business performance. For CFA and FRM preparation, focus on how FIFO affects financial statements and why comparisons with LIFO require adjustment. Once these links are clear, FIFO-related questions become much easier to handle.
