What Is FIFO?
FIFO is a cost-flow assumption, not a physical requirement. It says that for accounting purposes, the first units purchased are treated as the first units sold, regardless of which items actually leave the warehouse. As a result, cost of goods sold reflects older purchase prices while ending inventory reflects the most recent ones, keeping the balance sheet figure close to current replacement cost.
FIFO is permitted under both US GAAP and IFRS, which makes it the most widely used inventory method globally. For many businesses it also mirrors physical reality — grocers, pharmaceutical distributors, and other sellers of perishable or dated goods genuinely move their oldest stock first — which makes the accounting intuitive to explain and audit.
How FIFO Flows Through the Statements
A simple example makes the mechanics clear. Suppose a retailer buys 100 units at $10 in January and another 100 units at $12 in June, then sells 100 units in the fourth quarter. Under FIFO, COGS is 100 × $10 = $1,000, and ending inventory is 100 × $12 = $1,200. Under LIFO, the same sale would produce $1,200 of COGS and only $1,000 of ending inventory.
In an inflationary environment, FIFO therefore reports higher gross profit, higher pre-tax income, and a higher inventory balance than LIFO. The trade-off is taxes: more reported income means more cash paid to the government today. In a deflationary environment the effects reverse, with FIFO showing higher COGS and lower earnings than LIFO.
Why FIFO Matters for Analysis
Analysts care about the method because it changes comparability. Two identical companies can report different margins, inventory turnover, and current ratios purely because one uses FIFO and the other uses LIFO. When a US company reports under LIFO, its footnotes disclose a LIFO reserve that lets analysts restate inventory and COGS to a FIFO basis for apples-to-apples comparison.
Interviewers frequently test this topic with a question like which method produces higher net income when prices are rising. The expected answer is FIFO, along with the follow-through effects: higher taxes paid, a stronger-looking balance sheet, and gross margins that can be flattered by old, cheap inventory layers rather than genuine pricing power.
