Inventory accounting is the method by which a business determines the value of assets both for financial statements and tax purposes. Inventory is comprised of fixed assets that are intended for sale or being used in production. The value of your inventory is determined by taking the value of the beginning inventory, adding the net cost of purchases, and then subtracting the cost of goods sold. This results in the ending inventory value. Retailers and manufacturers cannot expense the cost of goods sold until those goods have actually been sold. Until then, those items are counted as assets on the balance sheet.
Common Inventory Valuation Methods
The methods a company uses to value the costs of inventory have a direct effect on the business balance sheets, income statements and cash flows. Three methods are widely used to value such costs. They are First-In, First-Out (FIFO), Last-In First-Out (LIFO) and Average Cost. Inventory can be calculated based on the lesser of cost or market value. It can be applied to each item, each category or on a total basis.
FIFO operates under the assumption that the first product that is put into inventory is also the first sold. An example of this in action can be made when we assume that a widget seller acquires 200 units on Monday for $1.00 per unit. The next day, he spots a good deal and gets 500 more for $.75 per unit. When valuing inventory under the FIFO method, the sale of 300 units on Wednesday would create a cost of goods sold of $275. That is, 200 units at $1.00 each and 100 units at $.75 each. In this way, the first 200 units on the income statement were valued higher. The remaining 400 widgets would be valued at $.75 each on the balance sheet in ending inventory.
LIFO assumes instead that the last unit to reach inventory is the first sold. Using the same example, the income statement and balance sheet would instead show a cost of goods sold of $225 for the 300 units sold. The ending inventory on the balance sheet would be valued at $350 in assets. When this method is used on older inventories, the company’s balance sheet can be greatly skewed. Consider the company that carries a large quantity of merchandise over a period of 10 years. This accounting method is now using 10-year-old information to value its assets.
Average Cost works out a weighted average for the cost of goods sold. It takes an average cost for all units available for sale during the accounting period and uses that as a basis for the cost of goods sold. To site our example again, we would calculate the cost of goods sold at [(200 x $1) + (500 x $.75)]/700, or $.821 each. The remaining 400 units would also be valued at this rate on the balance sheet in ending inventory.
A less commonly used, but important method to valuation is called specific identification. This method is used for high-end items that are more easily tracked. In some cases, this method can be used for more common items, but less value is realized from this accounting method is such cases. This is because powerful and detailed tracking software is required to employ specific identification on large numbers of goods. The cost of such software often outweighs the financial benefits that might be gained.
Inflationary Effects on Valuation
No matter how you look at it, you are still coming up with 700 widgets that cost you a total of $575. This would all be well and good if the value of money remained static. However, market conditions change causing inflationary changes. When this happens, your accounting method can have a strong impact on how healthy the business looks on income statements and balance sheets. The affects cash flow when businesses seek credit to pay for ongoing operations.
When prices are rising (and they usually are), each of these valuation methods produces a different result on a company’s finances. Using FIFO under such conditions will show a greater value on the balance sheet, thereby increasing tax liabilities but also improving credit scores and the ability to borrow cash for ongoing operations. Older inventory is being used to determine the cost of goods sold and newer inventory is being used to report assets.
LIFO decreases the value on the income statement, but can reduce the level of depreciation you are able to take on assets. This is good for taxes but bad for borrowing. Industries most likely to adopt LIFO are department stores and food retailers. The method is rarely used in defense or retail apparel.
When prices are falling, the effect on FIFO and LIFO values is reversed. FIFO produces a lower income statement and higher balance sheet. LIFO produces a higher income statement and a lower balance sheet. In either case, Average costs falls somewhere between, while specific identification will give the most accurate and reliable results.
It is important to understand that LIFO is only used widely in the United States. This valuation method is disallowed under International Financial Reporting Standards. When firms adopt LIFO, it is for the tax advantages during periods of high inflation. Once adopted however, switch back to FIFO during a period of market growth can be painful. The switch will create an artificially lower net income.
Making the Commitment
The problem with committing to either FIFO or LIFO is found in tax filing. Once a company uses one or the other on its tax filing, it must use the same method when reporting to shareholders. So using one method to a company’s benefit on taxes can harm earnings per share. In either case, the company’s financial statements must disclose the method used. It must also disclose the LIFO reserve, or the difference in value between what the inventory would have been worth under FIFO accounting.
The method a company chooses does not necessarily have to reflect the actual flow of goods. The method chosen will be used for tax and accounting benefits and will rarely be based in reality.