Legal Definitions - FIFO accounting

FIFO accounting stands for First In, First Out accounting. It is a method businesses use to value their inventory and calculate the cost of goods sold. Under FIFO, it is assumed for accounting purposes that the very first items a business purchased or produced are the first ones it sells, uses, or disposes of.

This method impacts how a company's financial statements are presented. When costs are generally rising, FIFO typically results in a higher reported value for the remaining inventory and a higher net income (profit) compared to other inventory valuation methods. While this can sometimes lead to higher income taxes, it can also make a business appear more financially stable and attractive to lenders, potentially helping them secure loans on more favorable terms.

• Example 1: A Fresh Produce Market

  Imagine a local grocery store that receives daily deliveries of fresh fruits and vegetables. To minimize spoilage and ensure customers always get the freshest items, the store physically arranges its produce so that the oldest stock is at the front, to be sold first. For accounting purposes, when the store calculates the cost of the produce it sold that week, it uses the cost of the *earliest* batches of produce it purchased, even if a newer batch was accidentally sold first. This reflects the FIFO principle by assuming the first produce bought was the first sold, impacting their reported profit margin for those sales.

  How it illustrates FIFO: The store's accounting system assumes that the cost of the first-received produce (the "first in") is assigned to the produce that was sold (the "first out"), which aligns with the practical need to sell perishable goods quickly.

• Example 2: A Fashion Boutique

  A clothing boutique purchases new collections of dresses and accessories every season. When a new shipment arrives, the boutique's inventory management system, using FIFO, assumes that the items from the previous season's purchase are the first ones to be sold. If the cost of acquiring new inventory has increased over time, applying FIFO means that the cost of goods sold will reflect the lower prices of the older inventory, leading to a higher reported gross profit for the boutique. The remaining inventory on the books would then be valued at the more recent, higher purchase costs.

  How it illustrates FIFO: The boutique's financial records attribute the cost of the oldest inventory items to the sales made, even as newer, potentially more expensive, inventory arrives. This method helps the business understand its profitability based on the assumption that older stock is cleared first.

• Example 3: A Pharmaceutical Manufacturer

  A company that manufactures over-the-counter medicines buys large quantities of raw chemical compounds. Each batch of chemicals has an expiration date and a specific purchase cost. Using FIFO accounting, the company's financial records assume that the earliest purchased batches of chemicals are the first ones used in production. When calculating the cost of manufacturing a batch of medicine, the accounting system assigns the cost of the oldest chemical inventory to that production run. This is crucial for accurate financial reporting, especially if the price of these raw materials fluctuates significantly between purchases.

  How it illustrates FIFO: The accounting method aligns with the practical necessity of using older, potentially expiring, raw materials first. It ensures that the cost of goods manufactured reflects the cost of the earliest acquired components, impacting the company's reported production costs and profitability.