In retail and wholesale sales, solid profits result from inventory that is closely managed. In this blog, we will discuss inventory valuation and accounting principles. We will cover why it is so important to value your inventory, different methods for inventory valuation, and how you should choose your inventory valuation method based on your business.
Generally speaking, inventory are goods that can be classified into 3 stages:
Based on your business needs, internal accounting staff may need to assign value to inventory and classify it as a company asset since inventory can turn into cash in the near future. In order to accurately value your company, all your company’s assets may need to be assessed.
There are two methods of determining income and expenses for accounting purposes: cash accounting and accrual accounting.
According to the Internal Revenue Service (IRS) if your business is holding inventory, then you are required to use the accrual method of accounting.
In accrual accounting, a transaction is recorded when it is earned, which is triggered by generating an invoice or receiving a bill. This is why it is essential to track your inventory along every phase of the business cycle.
However, the 2017 US Tax Cuts and Jobs Act states that “if your business has gross receipts of less than $25M, you can treat your inventory as “non-incidental material and supplies.” In layman’s terms, this means that the items in your inventory need not be valued and considered as assets of the company as they are bought for resale. In this case, you can use the cash method of accounting.
At the beginning and end of the fiscal year, inventory valuation is a must. For valuation purposes, you must:
Since inventory moves among different stages in your organization, it’s challenging to track all the costs of individual items. GAAP provides businesses with helpful guidelines to properly evaluate their inventory.
A company can choose from various methods to determine its inventory costs suggested by GAAP. GAAP refers to a standard set of accounting principles that have been issued by the Financial Accounting Standards Board (FASB). GAAP suggests that businesses use one of two different inventory accounting methods – first-in-first-out (FIFO) or last-in-first-out (LIFO).
FIFO stands for first-in-first-out. It is a method of inventory management and valuation in which goods produced or acquired first are sold, used, or disposed of first. In other words, goods are sold in the order they were received and subsequent shipments of the same item go to the back of the line.
For reporting purposes, FIFO assumes that assets with the oldest costs are included in the income statement’s cost of goods sold (COGS). So, if you sell a product, the cost of goods sold by using the FIFO method is the value of the oldest inventory. FIFO is one of the most popular in inventory valuation methods.
Using the FIFO method has some significant advantages:
LIFO stands for last-in-first-out. It is a method of inventory management and valuation in which goods produced or acquired most recently are recorded as sold first. In other words, goods that were just received are accounted for ahead of stored backstock of the same item. The cost of the newest products is the first to be accounted for as the cost of goods sold (COGS), whereas the lower price of older goods are counted in inventory.
Some accountants in the US often advise using the LIFO method for your inventory accounting when you have stock with frequently changing costs. Using LIFO as a preferred method for such scenarios helps match the latest cost of inventory with the sales revenue of the current period. This can be a more straightforward approach for initial inventory valuation as well as for tax filing purposes.
Unlike FIFO, LIFO has some disadvantages:
Let’s understand how FIFO is used to calculate Cost of Goods Sold (COGS).
|Buys an Item||$100|
|Buys the same item after inflation||$150|
|Sells an item for $175||-$100|
In the FIFO method, when calculating profit, its initial/oldest purchasing cost is subtracted from its selling price to calculate the reported profit.
The same example used earlier can be used to show the LIFO method for calculating the cost of goods sold (COGS).
|Buys an Item||$100|
|Buys the same item after inflation||$150|
|Sells an item for $175||-$150|
In the LIFO method, when calculating profit, the most recent purchasing cost is subtracted from its selling price to calculate the reported profit. As you can see, using the LIFO method for inventory valuation and accounting lowers your return profit.
FIFO or LIFO are the methods that companies use to assess their inventory and calculate profit. The amount of profit a company generates affects their income taxes.
The differences between FIFO and LIFO are shown below.
|Meaning||The first-in-first-out or the FIFO method assumes that the oldest products in a company’s inventory are sold first.||The last-in-first-out or the LIFO method assumes that the last item of inventory purchased is the first one sold.|
|No restrictions by GAAP or IFRS||IFRS forbids LIFO method|
|Recording keeping||In the FIFO method, the number of journal entries decrease||In the LIFO method, the number of journal entries increases|
|Impact of inflation||Decreases the COGS and increases the net profit||Increases the COGS and decreases the net profit|
We can say with certainty that the higher the cost of inventory, the lower the profit and the tax rate. The lower the cost of inventory, the higher the profit and the tax rate.
To know which method is best suited for your business, you need to look at the way your inventory costs are changing.
Generally Accepted Accounting Principles, sets the standards for accounting procedures in the United States. Under GAAP, both FIFO and LIFO are allowed.
However, International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Body (IASB) does not permit use of the LIFO method.
Outside of the US, most other countries follow the rules laid down by the International Accounting Standards Board (IASB). This is the reason why most US based companies use the LIFO method for local financial statements and switch to the FIFO method for their overseas operations.
If you ever decide that it would be ideal for your business to switch from the LIFO method to the FIFO method, you need to file a FORM 970 with the IRS. You are allowed to go back to LIFO only if the IRS gives specific permission.
In a nutshell, we have learned about inventory valuation and its importance in business to accurately determine the total value of all your assets and liabilities. While we have seen both FIFO and LIFO methods of inventory valuation, one thing is clear. No method is a foolproof solution for your business. Both methods have their pros and cons. As such, you should choose the method that best suits your business. If you are a firm that operates internationally, FIFO is the best method outside the US because the LIFO method doesn’t meet compliance requirements in most countries.
Cin7 was built with modern businesses in mind and only supports the FIFO method. Cin7’s inventory and order management software offers a cloud-based solution that integrates all your sales channels into a single platform. Cin7 provides advanced automation processes to create seamless transactions centered around a positive customer experience.
Ditch the spreadsheets and stop manual data entry. Reach new markets with Cin7’s inventory and order management system. Check out our product overview video here.
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