What income statement account is linked to inventory on the balance sheet?

2. Influence of inventory valuation methods on the cost of goods sold

US GAAP allows several ways to measure the cost of inventory:

  • first-in, first-out (FIFO);
  • last-in, first-out (LIFO);
  • weighted average;
  • retail method (or identified cost of the specific item that is used for unique goods); or
  • standard costing (for production companies).

The first three methods are the most commonly used. Interesting to note, unlike US GAAP, IFRS allows the use of the FIFO and weighted average methods, but not the LIFO method.

The FIFO method assumes that the first unit bought or produced by the company would be the first to sell. For example, Buddy Co sews fashionable handbags in batches of 10 units each. The cost of a handbag from the first batch was $100. But due to an increase in leather prices, the cost increased to $ 120 per a handbag in the next batch. At the end of the reporting period only 10 handbags were sold. Following the FIFO method, the company records $1,000 as the cost of goods sold (10 units x $100). Finished goods valued at $ 1,200 would appear on the balance sheet as an unsold asset.

The LIFO method stipulates that the last unit bought or produced by the company is sold first. Referring to the example above for the LIFO method, the company would expense $1,200 as the cost of goods sold and show $1,000 as the inventory value on its balance sheet.

Under the weighed average cost method, the cost of goods sold and closing inventory is determined as a weighted average of all units available for sale during the accounting period. In our example, the average cost for handbags would be $110 per unit, calculated as [(10 x $100) + (10 x $120)] ÷ 20.

These three examples illustrate that in the situation of rising prices the FIFO method leads to smallest possible expenses (cost of goods sold), hence the company will show higher profits. At the same time, taxes would be higher as well. The LIFO method helps to overcome the drawbacks listed above, however, the closing inventory balance would not be so relevant and may include obsolete or out of fashion (obsolete) goods. The weighted average cost method is quite straightforward and provides average income results.

In the terms of high inflation rates the weighed average cost or the FIFO methods are inappropriate to use for the purpose of cash flow management. Their application leads to outflow of liquid funds and reduction of purchasing power of the business, i.e. the company may not have enough money to buy materials for the next batch of goods. However, if the economy is quite stable those methods show their strong sides. It should be noted, that once one method of inventory valuation is elected, no further changes without significant reasons are allowed.

3. Special cases: impairment, launching of new product, cut off

Inventory is measured at the lower of cost or market value which is limited to estimated sales price less reasonable cost to complete and sell it (being the net realizable value in practice). If cost exceeds market value, the impairment of inventory occurs and it should be fully disclosed. A write-down is generally required unless the decline is due to seasonal price fluctuations.

For instance, if Buddy Co has a line of handbags that became out of fashion and the expected selling prices less costs to sell are lower than the carrying value of these old fashioned goods, then a write-down is recognised in the income statement. Generally, the adjustment is made to the cost of goods sold. In case impairment is material to financial statements, it is disclosed separately. It should be noted that unlike IFRS, when a write-down occurs, no subsequent reversal is permitted under US GAAP.

Inventory manufactured prior to regulatory approval (pre-launch inventory) is capitalised but immediately reserved for though other operating expenses, until there is a high probability of regulatory approval of the product. At the point when a high probability of regulatory approval is obtained, the provision recorded is reversed via other operating income, up to no more than the original cost.

Cut-off errors are relatively common, and may be a reason for unexpected changes in gross profit margins. Finished goods should be derecognised when an entity losses control over these goods, but not when the goods are paid for or the goods are delivered to the workshop, etc.  For more information about cut-off and shipping terms, see article What are FOB shipping terms?

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