The way you value your inventory has a direct impact on a number of elements in your financial statements. Accounting for inventory directly impacts assets reported on your balance sheet and cost of goods sold recorded on your income statement. As you sell an item from your inventory, it moves from an asset to an expense.
It’s important to assign the correct dollar amount to inventory because this amount slowly converts to an expense and ultimately impacts your company’s bottom line. Analyzing the three main types of inventory valuation helps you decide which is most effective for your small business.
FIFO Method of Inventory Valuation
The First In, First Out (FIFO) method of inventory valuation assumes the earliest goods you purchase are the ones you sell first — first in, first out. Imagine that your business buys and sells folding chairs. On January 1, you purchase 250 chairs for $10 each. On January 4, you purchase another 200 chairs of the exact make for $8 each. On January 7, you sell 50 chairs.
Under the FIFO method, you sold goods that were among the first to be purchased. In this case, the cost of the 50 chairs you sold is $10 per chair, since the earliest chairs you bought cost $10 each. The remaining 200 chairs at $10 each and 200 chairs bought at $8 each go on your balance sheet as inventory.
This inventory method is most beneficial for a small business during inflationary periods. This is because the costs assigned to the oldest inventory are the lowest. Imagine you buy an item of inventory for $25. Six months later, you buy the same piece of inventory for $35. When one of the items is eventually sold for $50, the FIFO method dictates the cost of the good sold is $25. Therefore, the FIFO method is most advantageous when attempting to maximize net income.
Another advantage of the FIFO method is that it conceptually avoids obsolescence. Because you sell older inventory items first, inventory listings have a lower chance of reporting items too old to sell.
However, there are drawbacks to the FIFO method. Income taxes are higher, and your company needs more cash to pay that bill. In addition, with FIFO, current period costs aren’t reported in the current period. This makes the financial statements slightly inaccurate. In the second example above, although you pay $35 for your product in the current period, the actual expense recognized is only $25. Therefore, you must manage cash flows more actively.
LIFO Method of Inventory Valuation
The opposite of the FIFO method is the Last In, First Out (LIFO) method of inventory valuation. With LIFO, the last inventory items bought are the first ones to be sold. Using the same figures from the chair example above, when recording the sale of 50 chairs under the LIFO method, you record that the chairs sold were the last ones bought. In this case, the cost of the chairs sold is $8.
The remaining chairs — still 400 in total — are reported as 250 bought for $10 each and 150 bought at $8 each. Again, these remaining 400 chairs are reported as inventory.
When selecting the LIFO method in an inflationary period, your company’s tax bill is lower. This alleviates cash flow requirements and creates an unreported income tax deferral. Another advantage is the accuracy of the timing of expense recognition, as expenses are actually reported in the period they occur. In addition, if you want to avoid writing off the future value of inventory, you should opt for this method because inventory is already understated.
A potential downside to the LIFO method is that it typically reduces your net income compared to the FIFO method. In addition, future net income is higher, a fact a small business must understand and anticipate from an income tax standpoint.
Another downside to the LIFO method is it may not align with the actual flow of goods in certain industries, such as the food industry, where perishable inventory is best managed under FIFO. A company that handles perishable goods needs to rotate stock and manage expiration dates, so it physically sells the oldest inventory goods first, assuming the products are still good.
Using the Weighted-Average Method
The weighted-average inventory valuation method applies the same inventory cost to every unit, regardless of the actual cost of each specific item. The clear benefit of the weighted-average method is its simplicity. You don’t need to track what you sell and when you sell it for inventory-costing purposes. Instead, you only maintain the total dollar amount of inventory and the quantity in stock for each inventory item.
If you spend $4,100 on two orders that resulted in 450 chairs, the average price per chair is $9.11. Therefore, when you sell 50 chairs, the cost of these chairs is $9.11 per chair, and all remaining chairs in ending inventory have a cost of $9.11.
Another benefit of this method is standardized expenses across inventory batches. For example, if you have a manufactured batch that has higher than normal waste, the cost of that waste is allocated across all batches, keeping the cost of all items the same.
The weighted-average method does have disadvantages. It doesn’t match any inventory flow, and actual expenses are never explicitly assigned to the items sold. Net income reported under the weighted-average method always falls between the amount reported under FIFO and LIFO. Therefore, future tax benefits and cash flow advantages are minimized.
Impact of Valuation Methods on Financial Statements
In the examples above, the difference between the cost of goods sold under LIFO and FIFO was $2 per chair, for a total of $100 for the sale of 50 chairs. This means the cost of goods sold expense is $100 higher under FIFO. This results in net income being $100 less under FIFO, and there’s now less income to report on your taxes. In addition, this $100 difference is buried in the balance sheet. The cost of ending inventory under the LIFO method is $100 greater than under FIFO.
Considering Inflation When Choosing a Valuation Method
When operating in an inflationary economy, prices of goods purchased increase over time. This means net income is highest under the FIFO method because the cost of goods sold reflects the oldest prices. Meanwhile, inventory is highest under the LIFO method because the last items purchased — at the highest prices — are in inventory.
During inflationary times, average costing calculations produce cost of goods sold and inventory calculations in between the numbers produced under FIFO and LIFO.
How to Select an Inventory Method
When choosing an inventory valuation method, consider a few elements. First, you should identify the cash flow implications and evaluate what cash flow might look like in the next three to five years.
Second, consider the impacts on your financial statements. Will you benefit most from having higher net income? Does your balance sheet need to report higher assets for financing purposes?
Third, consider the actual flow of materials. The selection you make must be substantiated, an element especially important if your inventory flows in a specific manner, such as with perishables.
Ultimately, the FIFO, LIFO, and weighted-average inventory valuation methods grant your business flexibility in financial reporting. As a small business owner, you want to understand the implications of each method, and enjoy the benefit of having the freedom to choose which method works best for your business.
Do U.S. or Canadian Inventory Valuation Methods Improve Balance Sheets?
Inventory valuation methodologies differ in the United States and Canada, and this can have a noticeable impact on your business’ balance sheets. Read on to learn about key differences between both sets of methods.
U.S. GAAP and IFRS Accounting Standards
Accounting methodology in the United States is dictated by U.S. Generally Accepted Accounting Principles, or U.S. GAAP, which were adopted by the U.S. Securities and Exchange Commission. In Canada, the International Financial Reporting Standards (IFRS) have been the standard since 2011.
While progress has been slow, the SEC intends to move from GAAP to IFRS. Both sets of principles define inventory the same way, but there are significant differences between them, and these differences can impact your business.
Measurement of Carrying Value
The carrying value of inventory is the original cost of the asset less any accumulated depreciation, amortization or impairments. GAAP dictates that this value be equal to the lower of either cost or market value.
IFRS states that it should be the lower of either cost or net realizable value. In the United States, market value typically means the item’s replacement cost. Assume you have an inventory item that has an original carry value of $100.
The current replacement cost of the inventory item is $85, and its net realizable value is $95. In the United States, the carry value of this item would be adjusted to $85, while in Canada, it would be adjusted to $95.
With GAAP, you don’t need to use the same formula you use to determine the cost of inventory across all inventories that have the same nature and use to your small business. In Canada, this is the opposite. All inventories that have the same nature and use to your small business must have the same costing formula.
Asset Retirement Obligations
If an asset retirement obligation (ARO) is created during the production of inventory, GAAP states that it’s added to the carrying amount of property, plant and equipment used to produce the inventory. Under IFRS, this amount is accounted for as a cost of the inventory. It may be added to the carrying amount of your inventory.
Under GAAP, FIFO (first in first out), LIFO (last in first out), weighted average, and specific identification are all acceptable methods of cost determination for your company’s inventory. Under IFRS, on the other hand, LIFO is not permitted, and specific identification is required for certain types of inventory and in certain cases.
Reversal of Write-Downs
Under GAAP, write-downs taken to reduce inventories to the lower of their cost or market value cannot be reversed to increase valuations later. Under IFRS, these write-downs are reversible.
Is GAAP or IFRS Better?
There is no one-size-fits-all answer. Each set of standards has its strengths and weaknesses. Depending on your type of company and the types of inventories involved, GAAP or IFRS can be more advantageous by causing your balance sheet to increase.
Since companies in each country must adhere to their respective standards, there isn’t much you can do:The only solution would be to relocate your entire company to the other country if the inventory valuations would drastically improve by switching reporting standards.
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