The first-in, first-out (FIFO) accounting method has two key disadvantages. It tends to overstate gross margin, particularly during periods of high inflation, which creates misleading financial statements. Inflated margins resulting from FIFO accounting can result in substantially higher income taxes.
The FIFO accounting method is a system used to assign costs to inventory during an accounting period. FIFO assumes the first inventory manufactured or purchased during a period is the first sold, while the inventory manufactured or produced last is sold last. Therefore, inventory purchased early in the period gets assigned to cost of goods sold (COGS), and inventory purchased last, usually unsold, gets assigned to ending inventory.
The counterpart to FIFO is LIFO, or last-in, first-out. The LIFO method assumes goods manufactured or purchased last during a period are the first sold.
The simplest real-life example of FIFO is milk in a grocery store. The milk the store buys first is pushed to the front of the shelf and sold first. Milk purchased later gets buried in the back and is not sold until the earlier milk is gone.
When production costs rise, companies using the FIFO method to report COGS that do not reflect what materials actually cost at the time the financial statements are released. Instead, lower costs are assigned to the goods sold, resulting in inflated profits. Higher profits can lead to a higher income tax expense, which reduces cash flow and weakens a company's financial position for the next accounting period.