Every business that manages inventory must use an inventory accounting process to determine the value of the company’s inventory assets. There are several common inventory accounting methods that companies rely on to assign value to their inventory and maintain appropriate record-keeping. Inventory valuation is a critical business process that directly impacts profit and taxation.
A Definition of Inventory Accounting
Because inventory is a business asset, accountants must consistently and appropriately use an acceptable, valid method for assigning costs to inventory to record it as an asset. Raw materials, work in progress, and finished goods remaining on-site should all be considered part of the inventory.
Moreover, placing a value on inventory is critical since the inventory accounting method used directly impacts the amount of expense charged to the cost of goods sold during an accounting period and then, in turn, on the amount of income earned.
How Inventory Accounting Works
The basic formula for calculating the cost of goods sold during a period is the sum of your beginning inventory and your purchases minus your ending inventory, which means you need to accurately determine the value of your ending inventory with an appropriate inventory accounting method.
Thus, inventory accounting is a vital business practice for manufacturers, wholesalers, and retailers. Many of these product-based businesses face the challenges of assigning value to inventory on hand as opposed to inventory sold, since identical goods carry different prices as time goes by. However, businesses are required to commit to an inventory cost method in the first year of business, and while it’s possible to switch methods in later years, doing so can be exceedingly complex. Therefore, companies should carefully weigh inventory accounting methods to determine which method is most appropriate for the organization not only today, but as the company (and the amount of inventory managed) grows. There is more than one inventory accounting method to use to value inventory.
Types of Inventory Accounting
Accountants need to determine whether to use first in, first out (FIFO), last in, first out (LIFO), weighted average method, or specific identification method of inventory accounting. If older inventory is less expensive, and you use it first, you would choose the FIFO accounting method. Or, you could assume that you used the most recent, most expensive inventory using the LIFO accounting method.
If FIFO and LIFO will not work for your business for one reason or another, your other options include the weighted average method or the specific identification method. The weighted average method of inventory accounting uses the average cost of your total inventory to assign value to each item used, while the specific identification method involves tracking the cost of each inventory item separately and charging the specific cost of an item to the cost of goods sold.
Continue reading to learn more about each type of inventory accounting.
- FIFO Inventory Accounting Method – When using the FIFO method, accountants assume the items purchased or manufactured first are used or sold first, so the items remaining in stock are the newest ones. The FIFO method aligns with inventory movement in many companies, which makes it a common choice. Prices also rise each year, so accountants who assume the earliest items are the first used can charge the least expensive units to the cost of goods sold first. As a result, the cost of goods trends lower and leads to a higher amount of operation earnings and more taxes to pay. It also means that companies use oldest items first and don’t have to worry about expiration dates or inventory that does not move.
- LIFO Inventory Accounting Method – Accountants who opt for the LIFO method assume items purchased or manufactured last are sold first, so the items remaining in stock are the oldest. As such, this method does not follow most companies’ natural inventory flow and is banned by International Financial Reporting Standards. When prices rise, the last units purchased are the first used, so the cost of goods trend higher and results in a lower amount of operating earnings and fewer income taxes to pay. Companies using the LIFO method also struggle with obsolete inventory.
- Weighted Average Accounting Method – Companies opting for the weighted average method have just one inventory layer. They also roll the cost of new inventory purchases into the cost of existing inventory to determine a new weighted average cost that is readjusted as more inventory is purchased or manufactured.
- Specific Identification Method – The specific identification method requires companies to track the cost of each inventory item separately and charge the specific cost of an item to the cost of goods sold when you sell the specific item. Because this inventory accounting method requires a great deal of data tracking, it is best suited to high-cost items.
Choose an inventory accounting method that suitable for your business needs to maximize revenue potential while effectively managing record-keeping for tax purposes.
Recommended Reading on Inventory Accounting
For more information on inventory accounting, visit the following articles:
- What is GAAP? Learn about Generally Accepted Accounting Principles, Requirements and More
- 26 Inventory Management Pros Reveal the Most Important Feature to Look For in an Inventory Management Software System
- 29 Experts Reveal How Small Businesses Can Improve Their Inventory Management Processes
- What is Inventory Management Software?