How do you account for inventory valuation methods and changes?

1 FIFO and LIFO

FIFO (first-in, first-out) and LIFO (last-in, first-out) are two common inventory valuation methods that assume a specific order of inventory flow. FIFO assumes that the oldest inventory items are sold first, while LIFO assumes that the newest inventory items are sold first. FIFO results in a higher ending inventory value and a lower cost of goods sold, while LIFO results in a lower ending inventory value and a higher cost of goods sold. FIFO matches the current market value of inventory better, while LIFO matches the current cost of goods sold better.

2 Weighted Average and Specific Identification

Weighted average and specific identification are two other inventory valuation methods that do not assume a specific order of inventory flow. Weighted average calculates the cost of goods sold and the ending inventory value by using the average cost per unit of inventory. Specific identification assigns the actual cost of each inventory item to the cost of goods sold and the ending inventory value. Weighted average smooths out the fluctuations in inventory costs, while specific identification reflects the actual inventory costs.

3 Accounting for Inventory Valuation Methods

Inventory valuation methods must be applied consistently and disclosed in the financial statements. The choice of inventory valuation method affects the balance sheet, the income statement, and the cash flow statement. For example, using LIFO instead of FIFO will decrease the inventory and equity accounts, increase the cost of goods sold and tax expense accounts, and decrease the operating cash flow. The inventory valuation method also affects the inventory turnover ratio, which measures how efficiently a business sells and replaces its inventory.

4 Reporting Changes in Inventory Valuation Methods

Sometimes, a business may decide to change its inventory valuation method for various reasons, such as tax benefits, industry standards, or improved accuracy. However, changing inventory valuation methods is not allowed unless it results in a better reflection of the economic reality of the business. A change in inventory valuation method is considered a change in accounting principle, which requires retrospective adjustment of the prior periods' financial statements to reflect the new method. The business must also disclose the nature and justification of the change, the effect of the change on the financial statements, and the cumulative effect of the change on the retained earnings.

5 Inventory Adjustments and Errors

Inventory adjustments and errors are inevitable in any business that deals with inventory. Inventory adjustments are corrections made to the inventory records to reflect the actual physical count of inventory. Inventory errors are mistakes made in recording or valuing inventory transactions. Inventory adjustments and errors affect the financial statements differently depending on the type and timing of the adjustment or error. For example, an understatement of ending inventory in the current period will result in an overstatement of cost of goods sold and an understatement of net income in the current period, but will be reversed in the next period.

6 Inventory Valuation Methods and Best Practices

Inventory valuation methods and changes have significant implications for inventory accuracy and financial reporting. Therefore, it is important for a business to choose an appropriate inventory valuation method that suits its industry, operations, and objectives, and to apply it consistently and transparently. It is also important for a business to monitor and control its inventory levels, conduct regular physical counts and reconciliations, and identify and correct any inventory adjustments or errors as soon as possible. By following these best practices, a business can improve its inventory accuracy and financial performance.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?