FIFO has become the most popular accounting method U.S. businesses use to determine both the cost of the goods they sell and the value of the goods they have in their inventories. With about 53% of firms in the S&P 500 (Index: SPX) using the accounting method, which plays a big role in determining how profitable they are on paper, it's high past time we took a closer look at how the First In, First Out (FIFO) accounting method works!
For a really good introduction, here's Excel spreadsheet guru Leila Gharani's eight-and-a-half minute video explaining how the First-In-First-Out (FIFO) accounting method is used to calculate the Cost of Goods Sold (COGS) for a business.
While her examples reflect how a modest amount of inflation can affect a business' cost of goods sold, how might a surge of inflation like what the U.S. has experienced during the past two years affect how profitable it appears to be on paper?
For the answer to that question, let's turn to Breaking Bad Accounting's shorter video from September 2020, which compares how the different the net earnings (or profit) results are for firms using the different accounting methods. Given what happened after inflation was unleashed in 2021, it's somewhat prophetic (although their example is more fun to talk about!):
Under FIFO accounting rules, reported profits soar in an inflationary environment because the calculated Cost of Goods Sold lags behind the rising cost of replenishing their inventories with higher cost goods.
About 16% of the firms making up the S&P 500 use the Last In, First Out (LIFO) accounting method. The remaining firms utilize variations of the Average Cost method. Firms that use the LIFO method see much lower profits than FIFO firms report, while Average Cost firms come out somewhere in between these extremes.
During periods of deflation, the opposite pattern develops. LIFO firms will report the highest profits, FIFO firms will report the lowest, and Average Cost firms come out in the middle again. If prices were stable however, all three methods would produce identical results.
The United States is somewhat unique in allowing firms to utilize any of these methods, and the LIFO method in particular, which is banned under International Financial Reporting Standards. Despite that prohibition, major accounting firms like Price Waterhouse Coopers have recommended private U.S. firms adopt the practice because of the high inflation environment established during the past two years.