Inventory is one of the most significant assets for many businesses, and how you account for it can have a major impact on your bottom line. Under U.S. Generally Accepted Accounting Principles (GAAP), you have some flexibility in how you track and expense inventory. This choice influences everything from your tax bill to the financial ratios that lenders and investors use to evaluate your company's health.
Let's explore the common inventory accounting methods to help you make a strategic choice for your business.
When inventory is sold, your reporting method affects the cost of goods sold on your income statement and the value of the remaining inventory on your balance sheet. Here are four common methods for reporting inventory under GAAP.
With the FIFO method, you assume that the first items entered into your inventory are the first ones sold. During periods of rising prices, the items you purchased earlier are generally less expensive. As a result, using FIFO typically leads to a lower cost of goods sold, which in turn boosts your pretax profits.
While higher profits and a stronger balance sheet look great to investors, this method can lead to higher tax obligations because you're reporting more taxable income.
The LIFO method is the opposite of FIFO. Here, you assume the last items added to your inventory are the first ones sold. In an inflationary environment, these more recently purchased items are usually more expensive. This results in a higher cost of goods sold, which lowers your reported pretax profits.
The main advantage of LIFO is that it can defer tax payments. However, the lower profitability and reduced inventory value on your balance sheet might raise a red flag for lenders. It's also important to know about the LIFO conformity rule: if you use LIFO for tax purposes, you must also use it for your financial reporting.
If you want to smooth out the cost fluctuations associated with FIFO and LIFO, the weighted-average cost method might be a good fit. This approach assigns a single weighted-average cost to all units available for sale during a period.
This method is common for businesses that handle large volumes of similar or interchangeable products, such as commodities, manufacturers, and distributors. It produces a consistent per-unit cost, making financial reporting more predictable.
For businesses with unique, high-value inventory—like artwork, custom homes, or luxury cars—the specific identification method is often the most appropriate choice. With this method, each item is tracked and reported at its specific historical cost. That cost remains on the books until the item is sold.
This method offers the most accurate insight into a company's profitability for these types of goods. However, if an item’s market value drops below its carrying cost, a write-off may be necessary.
Selecting the right inventory accounting method is a strategic decision. You'll need to consider several factors, including:
Think about how each method will impact your financial ratios, which lenders and investors closely monitor. For example, FIFO can make your balance sheet look stronger but may increase your tax burden and strain cash flow. LIFO offers tax benefits but can make your profitability appear weaker.
Whatever method you choose, you must apply it consistently. Changing your inventory accounting method is considered a change in accounting principle under GAAP and requires justification, disclosure, and potentially retrospective application.
Choosing the optimal inventory accounting method is more than a bookkeeping exercise—it’s a critical business decision that affects your taxes, cash flow, and how stakeholders perceive your company. Our team can help you evaluate your options, make a strategic choice, and ensure your financial statements are clear and compliant.
Contact us today for help navigating your inventory accounting options.