A Guide to Inventory Accounting

Introduction

Inventory accounting is an essential aspect of financial management and significantly impacts business operations and profitability. The choice of inventory valuation method has far-reaching implications for profitability, financial analysis, and even taxes. Companies must carefully select and consistently apply the most appropriate inventory accounting method for their business models while also considering the financial impact and the management of inventory control.

What is Inventory Accounting?

Inventory accounting is a critical component of financial management for companies that make or sell tangible goods. Inventory accounting involves the methods and practices used to assign value to and record inventory on financial statements.

Inventory is an accounting term for goods that are either held for sale to customers or goods that are in the process of being converted to a product that is ready for sale. Broadly speaking, inventory breaks down into three categories: 1) raw materials, 2) work-in-progress, and 3) finished goods.

The main purpose of inventory accounting is to accurately reflect the value of inventory on the balance sheet and the cost of goods sold (COGS) on the income statement. The inventory accounting process ensures that a company’s financial statements provide a true and fair view of its financial position and performance.

The Importance of Inventory in Business Operations

Inventory represents one of the most significant assets for many businesses, especially those in the manufacturing and retail sectors. It can tie up substantial amounts of cash flow and resources, which impacts sales and costs, including the cost of labor and accounting software designed to accurately track inventory.

Effective inventory management is crucial because it directly affects a company’s profitability. Overstocking can lead to increased holding costs and obsolete inventory while understocking can result in lost sales and dissatisfied customers. Inventory is not just a static asset but a dynamic element that influences the overall efficiency and success of a company’s operations.

The Concept of Inventory Valuation

Inventory valuation is the process of assigning a monetary value to the items in a company’s inventory. This valuation is crucial for determining the cost of goods sold and, ultimately, the gross profit of a business.

The choice of inventory valuation method can also significantly impact various ratios and complicate the ability of analysts to compare financial statements between companies that choose different inventory accounting methods. Having said that, companies should choose the method that best reflects the flow of goods and their associated costs.

The Main Inventory Valuation Methods

There are several methods for assigning inventory value, each with different implications for financial reporting:

1. Specific Identification Method: This method matches specific costs to the exact items in inventory. It is commonly used for items that are not interchangeable, such as unique or high-value goods, as well as individual goods that are easy to track. The actual cost of each item is recorded, making it a precise but often cumbersome method. Additionally, this inventory accounting method matches the actual costs of specific inventory items to their actual physical flow.
2. Weighted Average Method: This method calculates an average cost for all inventory items available during the period. It is effectively a middle-ground approach that smooths out price fluctuations and simplifies accounting.
3. FIFO Method (First-In, First-Out): The FIFO accounting method assumes the oldest items in inventory are sold first. When costs rise over time, as is usually the case due to the presence of inflation, FIFO results in lower COGS and higher ending inventory values. This is because the lowest cost inventory is sold first, increasing gross profit, while the highest cost inventory remains on the balance sheet.
4. LIFO Method (Last-In, First-Out): The LIFO method, which is only permitted under United States Generally Accepted Accounting Principles (GAAP), assumes the newest inventory items are sold first. During inflationary periods, LIFO results in higher COGS and lower ending inventory values, reducing taxable income but also lower gross profit and higher ending inventory.

Note that the weighted average, FIFO, and LIFO methods are based on assumptions about the physical movement of inventory. These assumptions may differ from the actual movement of inventory. These methods would be used when it’s not practical to track each good individually.

Regardless of which method is used, companies should always verify their physical inventory by conducting regular inventory counts when possible. This will help ensure that the reported inventory will match the actual inventory.

Another method allowed under both US GAAP and IFRS is known as the retail inventory method (RIM). This method is usually a little less complex than the aforementioned methods since it relies on a general assumption known as the cost-to-retail ratio.

The cost-to-retail ratio is calculated as the cost of a product divided by its retail price. COGS is then estimated by taking the cost-to-retail ratio and multiplying it by the sales during the period. Of course, the retail inventory method works best when the markup is consistent across all products. If this is not the case, then the result will not be very accurate.

Impact of Inventory on the Balance Sheet and Income Statement

Inventory directly impacts both a company’s balance sheet and income statement. Inventory is an asset to a company (usually a current asset); therefore, the inventory value affects both the current and total assets of the business, as well as the business’s working capital.

On the income statement, cost of goods sold is subtracted from revenues to determine gross profit. The method used to calculate the inventory value (e.g., FIFO, LIFO, or weighted average) influences the COGS amount, which in turn affects gross profit, operating income, and net income.

As discussed previously, during inflationary periods, LIFO COGS will be higher, reducing gross profit and net income (but also reducing income taxes). Conversely, FIFO will show lower COGS, resulting in higher gross profit and net income.

Inventory Accounting and Financial Analysis

Inventory accounting plays a critical role in financial analysis. Professionals often analyze companies using inventory-related metrics, such as inventory turnover and days sales of inventory (DSI), to assess how well a company manages its inventory.

• Inventory Turnover: This ratio measures how often inventory is sold and replaced over a period. A higher turnover usually indicates efficient inventory management, while a lower turnover may suggest the company carries too much or slow-moving inventory.
• Days Sales of Inventory (DSI): An alternative to inventory turnover is days sales of inventory. DSI calculates the average number of days it takes to sell a company’s inventory. A lower DSI indicates a faster inventory turnover, which is generally positive for cash flow. Alternatively, a higher DSI indicates slower inventory turnover, which is generally a negative for cash flow.

Of course, these metrics and ratios are meaningless in isolation and should be compared to comparable companies or over time in order to better judge company performance.

The different inventory valuation methods discussed earlier will lead to differences in these ratios, affecting comparability. For example, LIFO will show a higher inventory turnover due to higher COGS and lower inventory values. However, this in and of itself does not mean the company is better at managing its inventory (especially if compared to a company that uses FIFO, which will have a lower turnover, all else being equal).

Inventory Accounting and Taxes

Inventory valuation methods may have significant tax implications, depending on the jurisdiction to which the taxes are subject. As discussed previously, US-based companies can use the LIFO method. This method normally results in higher COGS and lower taxable income. This results in a tax savings for companies that use this method.

However, the US Internal Revenue Service requires that if a company uses LIFO for tax purposes, it must also use LIFO for reporting purposes. In other words, the company must prepare its GAAP-based financial statements using LIFO if the company uses LIFO for tax purposes. This prevents companies from using LIFO to minimize taxes while then using FIFO to show better profitability to investors.

Inventory Management

Because of the investment in inventory, and how important it is for many businesses, effective inventory management is absolutely critical. Managing inventory isn’t just about counting the physical inventory, but also optimizing inventory levels and minimizing costs.

Effective inventory management is crucial for optimizing the balance between inventory costs and availability. Techniques include:

• Just-in-Time (JIT): This method involves ordering and receiving inventory components only when they are needed in the production process, reducing holding costs and minimizing waste. This contrasts with companies that hold excess inventory in anticipation of future orders. The just-in-time method reduces cash being tied up in excess inventory, thereby minimizing opportunity costs.
• Economic Order Quantity (EOQ): The economic order quantity is a set point designed to help companies minimize the cost of ordering and holding inventory. The cost of ordering inventory falls with the increase in ordering volume due to purchasing on economies of scale. However, as the size of inventory grows, the cost of holding the inventory rises. EOQ is the point that minimizes both of these inversely related costs.
• Perpetual Inventory System: The perpetual inventory system involves tracking and updating inventory records after every transaction of goods received or sold through the use of technology. For example, in a perpetual inventory system, the sale of an inventory item increases cost of goods sold in the accounting records, while the outbound movement of this inventory is also recorded in inventory-tracking software. These systems enable both accurate inventory records and up-to-date accounting records.
• Periodic Inventory System: Under this system, inventory levels are updated at specific intervals, usually at the end of an accounting period. While this system generally requires less reliance on inventory and accounting software, it requires a lot of time and labor to conduct a physical count of inventory. Because of this, the periodic system provides less timely information compared to the perpetual system but is generally easier to implement.

Additional Resources

Thank you for reading CFI’s guide on Inventory Accounting. To keep advancing your career and skills, the following CFI resources will be useful:

• LIFO vs FIFO
• Perpetual Inventory System
• CFI’s Guide to Financial Ratios
• CFI’s Accounting Fundamentals course
• CFI’s Accounting for Inventory course
• See all accounting resources