If you keep inventory in stock, it’s important to ensure that it’s accounted for properly. Inventory can affect your company in many ways, impacting cash flow, cost of goods sold, and your profit. Today, we’re diving into two popular inventory accounting methods and the ways you can value your inventory or assets.
What is Inventory Accounting
Inventory accounting values and accounts for changes in the inventory a company holds during a given period. It determines the value of assets during the three stages of production: raw goods, in-progress goods, and finished goods ready for sale. Each item in stock has a value recorded separately. In manufacturing processes, the value of an item can change depending on the stage of production. The sum total of all inventory item values is recorded as a company asset.
The accounting method you choose has a direct impact on the cost of goods sold calculation for the accounting period, and on net income earned. Companies use cost of goods sold (COGS) to determine the direct cost of producing the goods sold without taking overhead costs into account, and generally includes only direct materials and labor costs.
To calculate the cost of goods sold, add the beginning inventory and purchases, then deduct the ending inventory from that number in the following way:
Cost of goods sold = beginning inventory + purchases – ending inventory.
The method businesses use to cost their inventory directly guides the income and inventory value they report on their financial statements. Two popular methods to compute the cost of goods sold and ending inventory for a period are First In, First Out (FIFO) and Last In, First Out (LIFO).
First In, First Out Method
First In First Out assumes the first items purchased are the first items sold, and therefore the oldest items of inventory are sold first. This matches the actual movement of inventory in most companies. In times of inflation, the use of this method will generally show a higher gross profit as the cost of goods sold is based on the oldest items in inventory being sold. Of course, a higher gross profit generally leads to a higher net profit and higher business-related income taxes if all else is held equal.
Last In, First Out Method
The Last In, First Out method is the opposite of FIFO, where the most recent item purchased is the first item sold, so items considered still in stock are the oldest. The rules for using the LIFO method are complex and details are contained in Internal Revenue Code sections 472 through 474. Two methods used are the Dollar-value method and the Simplified dollar-value method. Both involve grouping goods and products into one or more inventory pools. In times of inflation, LIFO will generally result in lower gross profit (and related net profit) as the cost of goods sold is based on the most recent purchases. To adopt the LIFO method for tax purposes, you must inform the IRS by filing Form 970 (or a similar statement) with your tax return for the year you first use LIFO.
Once you choose between the two accounting methods, you then need to choose how you will value your assets/inventory, generally with one of the three methods: cost; lower of cost or market; or retail.
To value your inventory using the cost method, you must include all direct and indirect costs associated with the inventory. To view the rules associated with this method, visit the IRS website, or talk with your accountant.
Lower of Cost or Market Method
Under this method, inventory value is calculated by comparing the market value of each item on hand on the inventory date with its current market value and using the lower of the two. Generally, this method applies to inventory items on hand that were purchased, inventory-in-process, and finished goods. This method does not apply to goods accounted for under the LIFO method or goods on hand (or being manufactured for delivery) at a fixed price on a firm sales contract.
Under the retail method, the total retail selling price of goods on hand at the end of the tax year in each department or of each class of goods is reduced to approximate cost by using an average markup based on a percentage of the total retail selling price. Check out Publication 538 from the IRS to learn how to determine the average markup.
Special Rules and Considerations:
Certain businesses may be subject to uniform capitalization rules, which require a business to capitalize the direct costs and a portion of indirect costs for production or resale instead of documenting them as a current expense deduction. If you have questions about whether your business is subject to these rules, talk with your accountant. Additionally, small businesses can choose to not keep an inventory, but they must still use a method of accounting for inventory that clearly reflects income, such as treating the inventory as non-incidental materials and supplies, for example.
To help determine which method of inventory accounting and valuation makes the most sense for your business, reach out to your accountant to discuss your options.