FIFO, first-in, first-out, is the inventory cost flow assumption under which the earliest costs a business incurred are the first ones charged to cost of goods sold, so the units left in ending inventory carry the most recent costs. A cost flow assumption decides which recorded dollars move to expense when goods are sold, and it says nothing about which physical carton leaves the building. Cost of goods sold is the inventory cost charged against revenue in the period of the sale, so the assumption sets the expense on the income statement and the carrying amount on the balance sheet at the same time.
The Rule FIFO Falls Out Of
Nothing in the inventory regulations requires an election to put a taxpayer on FIFO. It is what the fallback rule produces. Goods taken in the inventory which have been so intermingled that they cannot be identified with specific invoices will be deemed to be the goods most recently purchased or produced, and the cost thereof will be the actual cost of the goods purchased or produced during the period in which the quantity of goods in the inventory has been acquired (26 CFR 1.471-2). Deeming the closing inventory to be the newest goods says the same thing as charging the oldest to cost of goods sold.
The tests an inventory has to meet sit above any single method. Where the use of inventories is necessary to determine a taxpayer’s income clearly, inventories are taken on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income (26 U.S.C. 471).
Consistency counts for more than the choice itself. Greater weight is to be given to consistency than to any particular method of inventorying or basis of valuation, so long as the method or basis used is in accord with 1.471-1 through 1.471-11. In respect of normal goods, whichever method is adopted must be applied with reasonable consistency to the entire inventory of the taxpayer’s trade or business, with two stated exceptions: goods inventoried under the last-in, first-out method authorized by section 472, and animals inventoried under the elective unit-livestock-price method authorized by 1.471-6 (26 CFR 1.471-2).
No Election of Its Own
Form 1125-A, which computes cost of goods sold, asks about method in one place, and the assumption it names is not FIFO. Line 9a asks the filer to check all methods used for valuing closing inventory: cost, lower of cost or market, other, and, for certain small business taxpayers, the non-incidental materials and supplies method, the applicable financial statement (AFS) method and the non-AFS method. Those last three cover a small business taxpayer that treats its inventory as non-incidental materials and supplies, one that conforms to its treatment of inventory in an applicable financial statement, and one with no such statement that uses the method of accounting in its books and records. Line 9c asks whether the LIFO inventory method was adopted this tax year for any goods and tells the filer to attach Form 970 if it was, and line 9d asks for the closing inventory figured under LIFO and the closing LIFO reserve (IRS, Form 1125-A, Rev. November 2024). The line-by-line arithmetic of that form is worked through in raw materials.
Where the regulations do name FIFO, they name it as one of the ordinary options. A small business taxpayer that treats inventory as non-incidental materials and supplies may determine the costs recoverable through cost of goods sold by using either a specific identification method, a first-in, first-out (FIFO) method, or an average cost method, provided that method is used consistently, and may not use the last-in, first-out method described in section 472 for that purpose (26 CFR 1.471-1).
That contrast is what a firm actually feels. Electing last-in, first-out takes a written election filed with the return and binds the taxpayer in later years, so a client on it has something on file. A client that has been on FIFO from the start has nothing on file, because there was never anything to file. A client that moved to FIFO from another method does have a filing, because a change involving the method or basis used in the valuation of inventories is a change in method of accounting, and securing the Commissioner’s consent to a change in method of accounting generally means an application on Form 3115 (26 CFR 1.446-1). The election mechanics, the book conformity condition and the reserve are set out in LIFO.
FIFO needs no permission outside the US filing rules either. It is one of the two cost formulas IAS 2 Inventories allows for interchangeable inventories, and the wider split between the two frameworks is covered in GAAP vs IFRS.
What FIFO Does to the Reported Numbers
Rising costs are the case that matters. FIFO charges the oldest and therefore cheapest costs to cost of goods sold, so the expense is lower, gross profit is higher, and, all else equal, taxable income is higher too. Ending inventory holds the newest costs, so the balance sheet figure sits closer to what the goods would cost to replace. Under US GAAP that figure is then carried at the lower of cost and net realizable value, a measurement rule that reaches inventory measured on any method other than last-in, first-out or the retail inventory method (FASB, ASU 2015-11, amending ASC 330-10-35-1B). Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation.
Falling costs reverse every part of that. The earliest costs are then the highest ones, FIFO sends more to cost of goods sold, and gross profit and taxable income both come in lower.
Say a distributor starts the year holding nothing, buys twice at rising prices, and sells part of what it bought.
Purchase, March 400 units at $9 3,600
Purchase, August 400 units at $11 4,400
Goods available for sale 8,000
Units sold 500
FIFO
cost of goods sold 400 at $9 plus 100 at $11 4,700
ending inventory 300 at $11 3,300The earlier layer is consumed in full before the later one is touched, and everything still on hand is priced at the most recent purchase.
Nothing about the year’s purchases or sales changes, only which costs land in expense and which stay on the balance sheet.
The assumption also moves both sides of an inventory ratio at once, which is why days inventory outstanding figures built on different assumptions do not compare.
What FIFO Is Commonly Confused With
The physical picking practice. In warehousing, retail and food handling, first-in, first-out names a stock rotation rule: the oldest case on the shelf is the next one shipped, so stock does not age out where it sits.
FIFO cost flow often does coincide with rotating the oldest stock out first, which is exactly why people conclude the accounting method requires it. It does not. The regulation deems the cost of closing inventory without identifying the goods with specific invoices, so a business can pick its stock in whatever order suits the warehouse and still report on FIFO (26 CFR 1.471-2).
The abbreviation carries two unrelated meanings outside accounting: a queue discipline in computing, where the first item into a buffer is the first one out of it, and a fly-in fly-out work roster.
If closing-inventory computations move to an offshore preparer, a trial task runs a block of your own files through the review chain before any client file depends on it.
