Manufacturers & Distributors ARTICLE -
Taking Stock

Inventory accounting requires careful consideration

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Inventory accounting requires careful consideration

Inventory may be the most costly operating item for any business that sells products. Thus, manufacturers make inventory control a top priority. Equally important to profitability, however, is inventory accounting. And it can be a challenge.

Inventory is a current asset on balance sheets. It’s also a part of the cost of goods sold on income statements. The difficulty is deciding how much it’s worth. This can be particularly problematic for manufacturers. Why? Because you must stock your plant with purchased parts and materials to produce goods, as well as stock subassemblies and end products awaiting shipment — all of which is inventory.

Unequal assets

Bear in mind that not all inventory is the same: Purchased parts don’t include labor costs, but end products include labor, parts and subassemblies. The challenge for you and your accountant is to decide which inventory costs to capitalize, which of the three methods to use in valuing inventory and what system to use for recording inventory.

Capitalization vs. expensing various costs is perhaps the most straightforward of inventory decisions. The materials, labor and overhead used in producing saleable goods all are part of inventory and can be capitalized. Costs such as advertising and delivery — which are incurred after goods are ready for sale — must be expensed.

Value is relative

Deciding how to value inventory can be more complicated. The three methods for doing it are weighted average, first in/first out (FIFO) and last in/first out (LIFO), but deciding which method is best for you may take some consideration. For example, let’s see what will happen under each method if you purchase five parts for $10 each and five parts for $20 each, and sell five parts in finished products:

1. Weighted average. Under this method, the parts mentioned above will be valued at $15 each. The total cost of inventory items available for sale — five parts at $10 ($50) + five at $20 ($100) = $150 — divided by the total units available for sale (10) gives an average of $15 per part. Subtracting $75 for the five parts sold in finished products leaves $75 in inventory.

2. FIFO. This method presumes that the first parts brought into a factory will be the first parts sold as products. Using the previous example, if you purchase the $10 parts two weeks earlier than the $20 parts, the $10 parts would be included in the five products sold a week after that. Thus, that would leave the five $20 parts in inventory, with a total value of $100.

3. LIFO. This method assumes that you use and sell the newest parts, which are typically more expensive. Thus, continuing the example above, using the LIFO method would use the $20 parts to make the five products that were sold. That would leave the five $10 parts — or $50 — in inventory.

When inventory costs are rising, LIFO offers tax benefits by reducing short-term profits. For financial reporting purposes, on the other hand, FIFO is better because it shows lower cost of goods sold and higher earnings. Unfortunately, federal law doesn’t allow you to use both. If you use LIFO for your balance sheet, you also must use it in accounting. (See the sidebar “LIFO not universally beloved” for additional information.)

Tracking inventory data

A third consideration with inventory accounting is how inventory data enters the accounting system. Most manufacturers use some combination of two opposite approaches: perpetual and periodic. Generally, the perpetual system tracks the cost of each sale in a running record while the periodic system uses a formula to determine the cost of goods sold after the annual physical inventory count.

The perpetual system requires technology such as bar code scanning but provides current balances for cost of goods sold and inventory accounts at any time. It can’t replace an annual physical inventory count, though, as the physical count verifies the accounting record. Manufacturers often use the perpetual system only for units, because it’s easier to maintain records in units than to track individual costs.

The periodic system requires no additional technology. Instead, it relies on the annual inventory count and a temporary account of purchases to date to determine the cost of the goods sold. Even though the system is cost effective, inventory balances aren’t adjusted until year end, and there are no updated inventory records.

Regardless of which accounting system and approach you use, the annual inventory count is essential for accurate financial reporting. It may be a burdensome process, but the annual physical count shows whether financial records are accurate as well as whether your internal inventory controls are effective.

No easy way out

Managing and accounting for inventory can be just as costly and time-consuming as counting it, but there is no room for shortcuts. Proper attention to inventory can turn red ink black while inventory neglect can have the reverse effect.

LIFO not universally beloved

When deciding which accounting method to use for valuing inventory, remember that last in/first out (LIFO) is an American invention. It’s acceptable in the United States , but it may not be viewed as favorably elsewhere.

In some countries, LIFO accounting isn’t allowed for tax purposes because it reduces taxes. In many countries, generally accepted accounting principles follow tax codes, making LIFO unacceptable.

Even when LIFO would technically be permitted in other countries, it often can’t be used because most firms sell their products on a first in/first out (FIFO) basis. The belief is that accounting should reflect what actually happens. That view is reflected even in the United States , where LIFO is allowed but not the method accountants and attorneys prefer.

If you conduct or are considering doing business outside the United States , it may be wise not to use LIFO. If your business is strictly domestic, keep in mind that LIFO is accompanied by additional disclosure requirements.

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