What’s the right inventory accounting method for your business?

Inventory is one of the most significant assets on a balance sheet for many businesses. If your business owns inventory, you have some flexibility in how it’s tracked and expensed under U.S. Generally Accepted Accounting Principles (GAAP). The method you use to report inventory can have a dramatic impact on your bottom line, tax obligations and financial ratios. Let’s review the rules and explore your options.

The basics

Inventory varies depending on a business’s operations. Retailers may have merchandise available for sale, while manufacturers and contractors may have materials, work in progress and finished goods.

Under Accounting Standards Codification Topic 330, you must generally record inventory when it’s received and the title (or the risks and rewards of ownership) transfers to your company. Then, it moves to cost of goods sold when the product ships and the title (or the risks and rewards of ownership) transfers to the customer.

4 key methods

While inventory is in your possession, you can apply different accounting methods that will affect its value on your company’s balance sheet. When inventory is sold, your reporting method also impacts the costs of goods sold reported on your income statement. Four common methods for reporting inventory under GAAP are:

1. First-in, first-out (FIFO). Under this method, the first items entered into inventory are the first ones presumed sold. In an inflationary environment, units purchased earlier are generally less expensive than items purchased later. As a result, applying the FIFO method will generally cause a company to report lower expenses for items sold, leaving higher-cost items on the balance sheet. In short, this method enhances pretax profits and balance sheet values, but it can have adverse tax consequences (because you report higher taxable income).
2. Last-in, first-out method (LIFO). Here, the last items entered are the first presumed sold. In an inflationary environment, units purchased later are generally more expensive than items purchased earlier. As a result, applying the LIFO method will generally cause a company to report higher expenses for items sold, leaving lower-cost items on the balance sheet. In short, this method may defer tax obligations, but its effects on pretax profits and balance sheet values may raise a red flag to lenders and investors.

Under the LIFO conformity rule, if you use this method for tax purposes, you must also use it for financial reporting. It’s also important to note that the tax benefits of using this method may diminish if the company reduces its inventory levels. When that happens, the company may start expensing older, less expensive cost layers.

3. Weighted-average cost. Some companies use this method to smooth cost fluctuations associated with LIFO and FIFO. It assigns a weighted-average cost to all units available for sale during a period, producing a consistent per-unit cost. It’s common not only for commodities but also for manufacturers, distributors and retailers that handle large volumes of similar or interchangeable products.
4. Specific identification. When a company’s inventory is one of a kind, such as artwork, luxury automobiles or custom homes, it may be appropriate to use the specific identification method. Here, each item is reported at historic cost, and that amount is generally carried on the books until the specific item is sold. However, a write-off may be required if an item’s market value falls below its carrying value. And once inventory has been written down, GAAP prohibits reversal of the adjustment.

Under GAAP, inventory is valued at the lower of 1) cost, or 2) net realizable value or market value, depending on the method you choose.

Choosing a method for your business

Each inventory reporting method has pros and cons. Factors to consider include the type of inventory you carry, cost volatility, industry accounting conventions, and the sophistication of your bookkeeping personnel and software.

Also evaluate how each method will affect your financial ratios. Lenders and investors often monitor performance based on profitability, liquidity and asset management ratios. For instance, if you’re comparing LIFO to FIFO, the latter will boost your pretax profits and make your balance sheet appear stronger — but you’ll lose out on the tax benefits, which could strain your cash flow. The weighted-average cost method might smooth out your profitability, but it might not be appropriate for the types of products you sell. The specific identification method may provide the most accurate insight into a company’s profitability, but it’s reserved primarily for easily identifiable inventory.

Whatever inventory accounting method you select must be applied consistently and disclosed in your financial statements. A change in method is treated as a change in accounting principle under GAAP, requiring justification, disclosure and, if material, retrospective application.

We can help

Choosing the optimal inventory accounting method affects more than bookkeeping — it influences tax obligations, cash flow and stakeholders’ perception of your business. Contact us for help evaluating your options strategically and ensuring your methods are clearly disclosed.

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