Inventory accounting method

What Is Inventory Accounting Method?

An inventory accounting method is a systematic approach used by businesses to value the goods they have on hand for sale and the cost of goods sold during an accounting period. These methods are a fundamental component of financial accounting and fall under the broader category of cost accounting. The choice of an inventory accounting method directly impacts a company's financial statements, specifically the balance sheet and income statement, by influencing the reported value of inventory²⁰ and the cost of goods sold (COGS). Companies must consistently apply their chosen inventory accounting method to ensure comparability of financial data across periods.

History and Origin

The need for structured inventory accounting methods arose with the growth of commerce and manufacturing, particularly as businesses began to carry significant quantities of goods. Historically, the specific identification method was used when items were unique and easily traceable. However, as production scaled and inventory items became interchangeable, this method became impractical.

The First-In, First-Out (FIFO) method is arguably the most intuitive and reflects the natural flow of perishable goods or items with expiry dates, where older stock is generally sold first¹⁹. The Last-In, First-Out (LIFO) method emerged in the United States during the 1930s, a period marked by economic upheaval and inflation¹⁸. It gained legal recognition in the U.S. tax code in 1939, allowing companies to use LIFO for tax purposes if they also applied it for financial reporting. The introduction of the dollar-value LIFO method in the 1950s made it more feasible for businesses with large and diverse inventories¹⁷.

Globally, accounting standards bodies have developed guidelines for inventory. The Financial Accounting Standards Board (FASB) provides guidance through its Accounting Standards Codification (ASC) Topic 330, Inventory, for U.S. Generally Accepted Accounting Principles (GAAP). In 2015, the FASB issued Accounting Standards Update (ASU) 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory, which aimed to simplify inventory measurement for companies using FIFO or average cost by requiring them to measure inventory at the lower of cost or net realizable value¹⁶. Meanwhile, the International Accounting Standards Board (IASB) governs inventory accounting under International Financial Reporting Standards (IFRS), primarily through IAS 2, Inventories¹⁵. IAS 2 prescribes the accounting treatment for inventories, including the determination of cost and subsequent recognition as an expense¹⁴.

Key Takeaways

• Inventory accounting methods determine the value of a company's unsold assets (inventory) and the cost of goods sold.
• The primary methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted Average Cost.
• The chosen method significantly impacts a company's reported net income and tax liability.
• U.S. Generally Accepted Accounting Principles (GAAP) allows all three main methods, whereas International Financial Reporting Standards (IFRS) prohibits LIFO.
• Consistency in applying an inventory accounting method is crucial for accurate and comparable financial reporting.

Formula and Calculation

Inventory accounting methods are cost flow assumptions, not necessarily reflections of the physical flow of goods. They dictate which costs are assigned to the cost of goods sold and which remain in ending inventory.

For the Weighted Average Cost method, the average cost per unit is calculated using the following formula:

After calculating the weighted average cost per unit, the cost of goods sold and ending inventory are determined by multiplying this average cost by the number of units sold and units remaining in inventory, respectively.

Interpreting the Inventory Accounting Method

The choice of inventory accounting method offers insights into a company's financial strategy and its reported financial performance, particularly in periods of changing prices.

When prices are rising (inflationary environment):

• FIFO generally results in a lower cost of goods sold and, consequently, higher gross profit and net income. This method leaves higher-cost, more recently purchased items in ending inventory on the balance sheet, which typically provides a more accurate reflection of the current market value of inventory¹³.
• LIFO typically leads to a higher cost of goods sold and, therefore, lower gross profit and net income. This can result in lower reported taxable income and reduced tax liability during inflationary periods¹². However, it often results in balance sheet inventory values that are significantly understated compared to current market values, as older, lower costs remain in ending inventory¹¹.
• Weighted Average Cost tends to produce results that fall between FIFO and LIFO, smoothing out price fluctuations.

When prices are falling (deflationary environment):

• FIFO would result in a higher cost of goods sold and lower net income.
• LIFO would result in a lower cost of goods sold and higher net income.

Understanding which inventory accounting method a company uses is essential for analysts and investors to accurately compare companies and assess their financial health.

Hypothetical Example

Consider "Gadget Co.," which sells a single type of electronic gadget. Here are its inventory purchases for March:

• March 5: 100 units at $10 each
• March 15: 150 units at $12 each
• March 25: 50 units at $14 each

Total units available for sale = 100 + 150 + 50 = 300 units
Total cost of goods available for sale = (100 * $10) + (150 * $12) + (50 * $14) = $1,000 + $1,800 + $700 = $3,500

Suppose Gadget Co. sells 200 units during March.

Using the FIFO method:
Since FIFO assumes the first units purchased are the first ones sold, the 200 units sold would consist of:

• 100 units from March 5 purchase ($10 each) = $1,000
• 100 units from March 15 purchase ($12 each) = $1,200
• Total cost of goods sold = $1,000 + $1,200 = $2,200

Ending inventory would consist of the remaining 50 units from March 15 ($12 each) and all 50 units from March 25 ($14 each):

• Ending Inventory = (50 * $12) + (50 * $14) = $600 + $700 = $1,300

Using the LIFO method:
LIFO assumes the last units purchased are the first ones sold. The 200 units sold would consist of:

• 50 units from March 25 purchase ($14 each) = $700
• 150 units from March 15 purchase ($12 each) = $1,800
• Total cost of goods sold = $700 + $1,800 = $2,500

Ending inventory would consist of the remaining 100 units from March 5 ($10 each):

• Ending Inventory = (100 * $10) = $1,000

Using the Weighted Average Cost method:

• Weighted Average Cost Per Unit = $3,500 / 300 units = $11.67 (approximately)
• Cost of goods sold = 200 units * $11.67 = $2,334
• Ending inventory = 100 units * $11.67 = $1,167

As demonstrated, the inventory accounting method significantly alters the reported cost of goods sold and ending inventory value, directly impacting a company's reported revenue and profitability.

Practical Applications

Inventory accounting methods are crucial in several real-world financial contexts:

• Financial Reporting and Analysis: Companies select an inventory accounting method to present their financial position and performance to stakeholders. Financial analysts use this information to compare companies, though they must consider the differing impacts of chosen methods on reported profitability and asset values.
• Taxation: The choice of inventory accounting method has direct implications for a company's tax liabilities. In the United States, LIFO can result in a higher cost of goods sold during inflationary periods, which leads to lower taxable income and reduced taxes¹⁰. The IRS requires companies using LIFO for tax purposes to also use it for financial reporting, a rule known as the LIFO conformity rule⁹.
• Pricing Decisions: Understanding the cost flow assumptions helps management make informed pricing decisions. If a company uses FIFO, its reported costs of goods sold might be lower than current replacement costs, which could influence pricing strategies.
• Inventory Management: While not a physical flow, the chosen inventory accounting method affects the valuation of inventory for internal management purposes, contributing to decisions regarding purchasing and stock levels.

Limitations and Criticisms

While inventory accounting methods provide a structured way to value inventory, they come with certain limitations and criticisms:

• Mismatch with Physical Flow: LIFO is often criticized because it rarely reflects the actual physical flow of goods for most businesses, where older inventory is typically sold first to avoid obsolescence. This can lead to an inventory balance on the balance sheet that reports costs from years or even decades earlier, which may not be relevant to current market conditions⁸.
• Outdated Balance Sheet Values: Under LIFO, especially during periods of inflation, the value of remaining inventory on the balance sheet can be significantly understated, as it comprises the oldest, lowest costs⁷. This can misrepresent a company's true asset base.
• Earnings Manipulation Concerns: The LIFO method can be used to influence reported income. For instance, if inventory levels decrease (a "LIFO liquidation"), older, lower-cost inventory layers might be recognized in COGS, leading to a temporary increase in reported profit that may not reflect ongoing business performance.
• International Prohibitions: A significant criticism of LIFO is its prohibition under International Financial Reporting Standards (IFRS), which are used in many countries worldwide. IFRS disallows LIFO due to its potential to distort profitability and financial statements, leading to difficulties for multinational companies that operate under both GAAP and IFRS. IAS 2 requires the use of either FIFO or the Weighted Average Cost method for inventory valuation.

Inventory Accounting Method vs. FIFO

An inventory accounting method is a broad term referring to the various principles and conventions businesses use to value their inventory and cost of goods sold. These methods are cost flow assumptions that determine how costs are matched against revenue.

FIFO (First-In, First-Out) is one specific type of inventory accounting method. It operates on the assumption that the first items acquired or produced by a business are the first ones sold. This approach generally aligns with the physical flow of most goods, particularly perishable items or those subject to technological obsolescence. Under FIFO, the oldest costs are expensed as COGS, leaving the most recent costs in ending inventory. This can result in a higher reported net income during inflationary periods compared to other methods, and the balance sheet value of inventory tends to more closely reflect current replacement costs. While FIFO is a method within inventory accounting, the broader term encompasses other methods like LIFO and Weighted Average Cost, each with distinct impacts on financial reporting.

FAQs

What are the main inventory accounting methods?

The three primary inventory accounting methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted Average Cost⁶. Each method uses a different assumption about the flow of costs through a business.

Why does the choice of an inventory accounting method matter?

The choice of an inventory accounting method significantly impacts a company's reported profitability, the value of its assets on the balance sheet, and its tax liability⁵. Different methods can lead to different financial outcomes, especially in periods of fluctuating prices.

Is LIFO allowed everywhere?

No, the LIFO inventory accounting method is primarily permitted under U.S. Generally Accepted Accounting Principles (GAAP). It is prohibited under International Financial Reporting Standards (IFRS), which are used in many countries around the world, due to concerns about its potential to distort financial statements.

How does inflation affect inventory accounting methods?

During periods of inflation (rising prices), the FIFO method typically results in a lower cost of goods sold and higher reported net income, while LIFO results in a higher cost of goods sold and lower reported net income. The Weighted Average Cost method produces results between FIFO and LIFO⁴.

What is the "lower of cost and net realizable value" rule?

This rule, applicable under both GAAP (for FIFO and Weighted Average Cost users) and IFRS, dictates that inventory should be reported on the balance sheet at the lower of its historical cost or its net realizable value (estimated selling price minus estimated costs of completion and disposal)³,². If the net realizable value falls below cost, an inventory write-down is required, recognizing a loss in the income statement¹.