Inventory accounting is the process of determining and keeping track of the inventory costs. You start with the inventory you have on hand. It doesn't matter when you sell the product, the value of your inventory will stay the same based on the general accepted accounting principles. Inventory can become complex considering price changes and quantity changes during an accounting period. The accounting method that a company decides to use to determine the costs of inventory can directly impact the balance sheet, income statement, and statement of cash flow. There are three inventory-costing methods that are normally used by both public and private companies.
Weighted Average
Some businesses use a technique called weighted average. Weighted average measures the total cost of items in inventory that are available for sale divided by the total number of units available for sale. The weighted average is usually calculated at the end of the accounting period. This inventory accounting method is used primarily by companies that maintain a large supply of undifferentiated inventory items such as fuels and grains.
First In, First Out
Another method used by many different companies is called the FIFO method, which stands for first in, first out. This means that the first items bought for inventory will be the first ones sold out. So the oldest inventory will be sold first, resulting in the newest items available for sale. On the income statement, the older inventory was cheaper, the cost of goods is less and income is higher. On the balance sheet, the remaining inventory is the newest and most valuable.
Suppose you buy five items at $15 apiece on January 21 and purchase another five items at $20 apiece on January 25. You then sell five items on January 30. Using first in, first out, the five items you purchased at $15 would be sold first. This would leave you with the five items that you purchased at $20, which would leave you an inventory value of $100.
Last in, First Out
This method, commonly referred to as LIFO, is based on the assumption that the most recent units purchased will be the first units sold. Therefore, the inventory that remains is always the oldest inventory. On the income statement, the newer more expensive inventory is sold so the cost of goods is higher and income lower. On the balance sheet, remaining inventory will be shown as an older and less valuable asset.
Suppose you purchase five items at $10 apiece on February 6 and five more items at $20 each on February 11. You then sell five items on February 20. The value of your inventory, using LIFO, would be $50, because the most recent items purchased, at a total value of $100 on February 11, were sold. You were left with the five items valued at $10 each.
But why is inventory important? Well, if inflation did not exist then all three methods would result in the same numbers. However, the market is more complicated. Over the long term, prices tend to rise, which means the choice of accounting method can dramatically affect valuation ratios.
If prices are rising, each of the accounting methods produces the following results:
First in, first out gives us a better suggestion of the value of ending inventory but it also increases net income because inventory that might be several years old is used to value the cost of goods sold. Increasingnet income looks good, but it also has the potential to increase the amount of taxes for a company.
Last in, first out is not a great suggestion of ending inventory value because the leftover inventory might be old, non wanted or unusable. This results in an assessment that is much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher.
When using average cost, the results produced usually lie somewhere in between FIFO and LIFO.
If prices are falling,
LIFO assigns the lower amount to cost of goods sold, yielding the higher gross profit and net income.
