Why is FIFO considered a close approximation of fair market value?

FIFO, which stands for "First In, First Out," is considered a close approximation of fair market value because it reflects the most recent inventory purchases in terms of cost and value. This method assumes that the oldest inventory items are sold first, meaning that the remaining inventory on the balance sheet consists of the newest purchases.

By accounting for inventory in this manner, FIFO effectively allows a company to present its assets at prices that are more current and relevant to today’s market conditions. As such, the valuations of inventory assets under FIFO closely align with what those assets might fetch in an open market scenario, making them a good representation of fair market value.

This aspect of FIFO is particularly important during times of rising prices. As the cost of goods increases, using FIFO means that the older, cheaper inventory is recognized as sold first. Consequently, the inventory remaining on the balance sheet will reflect higher-priced, newer inventory, giving a better indicator of the current market value when assessed.