FIFO is a popular inventory valuation method that can increase gross profit, balance sheet value, and reduce obsolete inventory write-offs. It requires selling the oldest inventory first and is based on the company’s accounting ledger. It can also help businesses have lower balances of obsolete inventory.
First-in, first-out (FIFO) is a common method of valuing inventory that offers many benefits to businesses, including higher gross profit figures, increased balance sheet value, and fewer opportunities for obsolete inventory write-offs. Inventory valuation is an important accounting concept for businesses. Companies use different valuation methods based on the company’s internal policy and the type of inventory sold to consumers. FIFO requires companies to sell the oldest inventory from the company’s financial inventory account first. Companies often keep detailed records in their accounting register in order to follow this principle.
Businesses that purchase inventory at various times throughout the year must keep individual records for each purchase. The items are posted to the accounting ledger on the date and the actual cost paid for each item. When selling inventory, FIFO accounting procedures will remove the oldest items first, even though the actual physical items may not represent the oldest items in inventory. Many companies do not track the oldest and most recent stock unless there is high risk or obsolescence or deterioration involved in the inventory. This valuation method mainly focuses on the company’s accounting ledger.
In theory, selling older inventory usually first removes the cheaper inventory from the company’s inventory asset account at cost of goods sold. Since gross profit is net sales revenue minus cost of goods sold, FIFO translates into higher gross profits. While some critics in the accounting profession do not prefer the FIFO inventory valuation for this reason, the method offers companies a significant advantage when reporting financial results to internal and external stakeholders.
A higher asset value on a company’s balance sheet generally increases the economic value of the company and improves the analysis of the financial report. Economic value often represents a company’s total assets minus its total liabilities. A positive number indicates that the company has higher economic value in the corporate environment. Inventory can be a major asset on a company’s balance sheet. Business owners and executives commonly conduct a financial report analysis to assess their company’s ability to meet short-term financial obligations. Large inventory balances are a current asset that improves the company’s financial ratios related to meeting short-term financial obligations.
FIFO can help businesses have lower balances of obsolete inventory on their ledger. Consistent removal of older inventories ensures that products with the highest likelihood of obsolescence are removed from the general ledger. A company with large amounts of obsolete inventory that becomes unsaleable must write off that amount against the company’s net income. While this write-off reduces the company’s tax liability, outside business stakeholders should see it as a weakness in the company’s inventory management process.
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