The way that FIFO accounting works is that it assumes that the first units that are put in an inventory are the first units to leave that inventory. In other words, FIFO assumes that when somebody orders something from your company, you are going to ship the oldest units that are in your warehouse to fill the order. FIFO is deemed to be the most effective way of understanding and measuring inventory when you have a whole bunch of different batches of products that are alike. FIFO, as opposed to LIFO, more accurately reflects the reality of business, because most companies do rotate their inventory in this particular way.

Why would you use FIFO inventory accounting practices as opposed to LIFO? LIFO seems to offer greater benefits, since it defers your tax payments. But there are some good reasons to use FIFO accounting instead.

Here's why:

1. Today's economy is constantly experiencing inflation. Because of this, beginning companies will use FIFO inventory accounting in order to make their balance sheet look better.
2. Because all of your new inventory units are going to be purchased at a higher price, if you keep it in your inventory then you will have this more expensive inventory listed as an asset on your books.
3. Using FIFO accounting practices to measure your inventory can actually help you get a loan from creditors more easily. How? Because you have those higher valued assets listed on your books, and the purchase cost of your sold goods is lower, then your books look better. You have more assets. Creditors like seeing higher assets more than seeing lower assets, obviously.

However, as your company grows and becomes more established, then you might want to think about changing the way that you measure your inventory. LIFO accounting actually tends to work better for larger companies. Why? Because you keep the lower priced inventory in your warehouse longer. This means that you won't be paying taxes on imaginary, or phantom income, that's based on inflation. LIFO accounting can help you pay less taxes because you defer your tax payments. However, LIFO accounting isn't as accurate a representation of what's really going on in your business as FIFO is. Also, federal law bans using LIFO accounting practices for anything other than inventory reporting. You can't use LIFO accounting to represent your company's financial state.

As an investor, it's important to know if company's that you have invested in or that you are thinking of investing in are using FIFO accounting or LIFO accounting. FIFO accounting actually gives investors a better understanding of the value of the ending inventory when it's put on the balance sheet. The deal with FIFO accounting is that it increases the net income reported on a balance sheet because you are using old inventory to determine the value of your cost of goods sold. While you might think that this is a good idea, don't forget that the amount of taxes is determined by the size of the net income of a company.