Business owners may recognize the classic inventory valuation methods (i.e. FIFO, LIFO, Weighted Average, etc.), but few know the direct impact that each method will have on their financials. The choice between inventory valuation methods can lead to drastic differences in net income, cost of goods sold, and ending inventory. Are the differences due to some sort of accounting magic? Certainly not! As accountants, we must analyze each method and apply the method that most accurately reflects periodic income. To help accountants with this decision, I will go through three common valuation methods and demonstrate the unique impact that each method will have on the financial statements.
Inventory Valuation Methods: FIFO (First In, First Out)
FIFO is based on the principle that the first inventory goods received will be the first inventory goods sold. FIFO results in the highest ending inventory, the lowest cost of goods sold, and the highest net income. This is because the oldest and lowest costs are allocated to cost of goods sold. Ending inventory is valued with the newest and highest cost; which most accurately approximates replacement cost. Net income will increase because the lowest costs were used; which is not an accurate reflection of current cost to current revenue. Another unique factor FIFO offers, is the ability to have the same amounts for ending inventory and cost of goods sold regardless of the use of periodic or perpetual inventory systems.
Inventory Valuation Methods: LIFO (Last In, First Out)
LIFO is based on the principle that the last inventory goods received will be the first inventory goods sold. In periods of rising prices, LIFO will result in the lowest ending inventory, the highest cost of goods sold, and the lowest net income. Ending inventory is smaller because the newest and highest prices are sold first, leaving the oldest and cheapest inventory on the books. Cost of goods sold is high because the newest and most expensive inventory is sold first. Net income is the lowest because revenues are matched with the highest inventory costs. LIFO eliminates holding gains because we are selling inventory with the newest cost.
LIFO does produce different ending inventory and COGS amounts when choosing between periodic and perpetual inventory systems. When using periodic inventory systems, costs from the end of the period are used first, regardless of when inventory was sold within that period. This results in the highest COGS and a lower ending inventory. When using perpetual inventory systems, the date inventory is sold determines which inventory costs are used. This results in a lower COGS and a higher ending inventory.
There are several important items to note before using LIFO. First, LIFO is susceptible to incurring obsolete inventory. This is because older inventory will continue to sit on the shelves and may become obsolete over time. Second, if LIFO is used in tax reporting, then LIFO is required to be used for financial statement preparation under US GAAP. Finally, International Financial Reporting Standards prohibit the use of LIFO. Each of these factors should be considered before adopting LIFO.
Inventory Valuation Methods: Weighted Average
Weighted average allocates the average period cost of all homogenous goods in inventory to individual items. At the end of each period, identical inventory items are combined for a total inventory cost. The total inventory cost is divided by the units of inventory available. This calculation provides us the average inventory cost per unit. COGS are determined by multiplying the average cost per unit by the amount of goods sold. Ending inventory is determined by subtracting COGS from the total cost of inventory (not the average!). Weighted average provides a middle ground for determining net income, ending inventory, and COGS.
It is important to note that QuickBooks only permits the use of weighted average. If you decide to use another inventory valuation method, you will have to manually override QuickBooks with journal entries.
Inventory management in your accounting system can be very challenging and confusing. Improper handling of inventory can cause wild swings in your financial reports. TGG Accounting can help clean up or implement these kind of best practices. Call us today.Written by: Jake Cavanagh TGG Accounting