ACCT 301 Inventory Accounting Methods Research Paper.pdf

INVENTORY ACCOUNTING METHODS 1

Inventory Accounting Methods

Intermediate Accounting ACCT-301-B01

Liberty University

INVENTORY ACCOUNTING METHODS 2

Abstract

This paper discusses the different ways inventory can be accounted for by businesses and also

addresses the different cost allocation methods allowed according to GAAP and IFRS. Also

included is information on how the choice of inventory cost allocation method effects everything

from the income reported on financial statements to the tax liability of a company.

INVENTORY ACCOUNTING METHODS 3

Inventory Methods

Inventory Management Systems and Methods

Inventory management is an important part of running a business. Having an accurate

count of inventory along with how you record the inventory is important, especially when

preparing financial documents. Inventory is considered an asset on the balance sheet, but

information that is related to inventory, such as cost of goods sold, are also tracked on other

financial reports such as the income statement. This data is factored into the information that is

financial statements more than the method that is used to allocate costs between the inventory

that is sold and the inventory remaining unsold at the end of the reporting period. How inventory

is treated has an effect on the financial statements produced by companies which is why it is

important for management to make an informed decision about which type of inventory cost

allocation system the company uses. Management needs to take into account what is more

important to them, income tax liability limitation, higher profits for calculation of higher bonuses

for managers, or neutrality where income tax liability and higher profits for determination of

bonuses are not important.

INVENTORY ACCOUNTING METHODS 4

Perpetual Inventory System

In a perpetual inventory system, inventory is continually adjusted to account for

positive and negative changes in the inventory count. The inventory account is adjusted each

time an inventory purchase or sale is made. This type of method requires an electronic inventory

system, such as the barcodes that would be used in a grocery store, in order to continually update

the inventory based on the sales made (“Investopedia stock analysis: Understanding Periodic Vs.

Perpetual Inventory”, 2015). Keeping a continual up to date count of inventory makes this

method more accurate when data on inventory is needed at any given time. This is due to the

adjusted at the end of a preset period established by the company. Even though in this inventory

system the inventory account is not continually adjusted to account for sales and purchases of

inventory, this information is continually accounted for in other asset and liability accounts such

as purchases, sales, accounts payable, and accounts receivable. Due to the fact that inventory is

not constantly monitored, it is necessary for a physical count of the inventory remaining to be

made at the end of the preset accounting period. Once the inventory count is made, the inventory

account is adjusted to reflect the purchases and sales that occurred during the period as well as

the actual count of inventory at the end of the accounting period. Because this system does not

INVENTORY ACCOUNTING METHODS 5

continually track inventory coming in and out, inventory counts are not accurate and up to date

throughout the period.

Businesses that sell lots of small items may choose this type of inventory system in order

to simplify their inventory accounting system. This type of system is also more suitable for

businesses that do not want to spend the money on an electronic system and employees that

would be needed to maintain and run the system that would be necessary for a perpetual

inventory system (“Investopedia stock analysis: Understanding Periodic Vs. Perpetual

Inventory”, 2015).

Cost Flow Methods

Average Cost Method

119).

Last In First Out (LIFO)

The last in first out (LIFO) method assumes that the last items added to the

inventory are the first items deducted from the inventory when a sale occurs. This method has

tax advantages during times when costs are rising and is the method that most closely relates to

INVENTORY ACCOUNTING METHODS 6

the actual physical flow of inventory (Muller, 2011, pg. 18). This method reduces income tax

liability by reducing reported profits but also has a positive effect on the reporting of cash flow.

Under the LIFO method, cost of goods sold would be higher and profits would be lower.

Companies whose management receive bonuses based on reported income would likely stay

away from this type of inventory cost allocation method. This method is popular with companies

that have high profits and want to limit their tax liability on theses profits, such as oil companies.

The LIFO method has not always been allowed. Prior to 1939, average cost and

FIFO were the only two inventory cost allocation methods that were allowed for determination

of income tax liability. During the 1930’s there was a push for the LIFO method to be approved

(Lessard, 2007).

Due to the income tax liability reduction possible from the LIFO method, the IRS

requires that a company that uses LIFO for income tax calculation must also use it in all of their

financial reporting. This rule also limits the use of LIFO to companies with whom LIFO

conforms most closely to their industries best accounting practices (Adams & Troutman, 2012).

This requirement prevents companies from using LIFO to reduce income tax and then use FIFO

to show higher profits on its financial statements. In recent years, there has been a push for LIFO

to be eliminated. The elimination of LIFO could create additional tax liabilities for companies

INVENTORY ACCOUNTING METHODS 7

that would assist with paying down the United States deficit. This push gained momentum

during the time oil companies were making record profits but they were using LIFO to reduce

their income tax liability.

First In First Out (FIFO)

The first in first out (FIFO) method works under the assumption that the first

items added to inventory are also the first items deducted from the inventory when a sale occurs.

This method has more tax advantages than LIFO during times when costs are declining and most

closely matches current cost with current revenues (Muller, 2011, pg. 18). Declining inventory

enter the market. Each reduction in inventory is eliminating the higher priced inventory items

first leaving the less expensive inventory items. This method is best for companies whose

inventory prices will continue to fall, however, it is also beneficial for companies whose

inventory prices continue to rise. Companies that are more concerned with reporting higher

profits in lieu of limiting their income tax liability would chose this method of cost allocation for

their inventory.

LIFO vs. FIFO

INVENTORY ACCOUNTING METHODS 8

LIFO and FIFO would be considered polar opposites with regards to inventory cost

allocation (Jesswein, 2010, pg. 53). These two methods can cause the greatest differences in

financial figures reported on the balance sheet and income statement (Jesswein, 2010, pg. 53).

Many companies tax liability concerns drive their choice for the inventory cost method they

choose. However, management of companies where bonuses are dependent on the amount of

income they have per their financial statements may be tempted to choose an inventory cost

method that shows higher profits instead of one that reduces the companies tax liability.

Conflicts could arise between management and stockholders on the inventory cost method that is

used. The LIFO method would lead to an increase in cash flow, which would be preferred by

While LIFO does reduce income tax liability and result in higher cash flows, it also reports lower

earnings. This is due to the inventory that is remaining at the end of the reporting period having

their value understated on the balance sheet. Because LIFO results in an understated value of

inventory, companies that use LIFO must also report the extent to which their inventory is

undervalued relative to them using FIFO or the average cost methods (Jesswein, 2010, pg. 54).

Businesses must weigh these factors to determine if LIFO is really the best system for them to

use.

INVENTORY ACCOUNTING METHODS 9

Generally Accepted Accounting Principles and International Financial Reporting

Standards

In the United States companies must report their financial information in compliance with

the Generally Accepted Accounting Principles (GAAP). GAAP is a set of guidelines created by

the Financial Accounting Standards Board that companies are required to follow with measuring

and reporting information in their financial reports (Spiceland, Sepe, Nelson, & Thomas, 2016,

pg. 8). Under GAAP, companies are allowed to use three different cost flow methods for their

inventory; the average cost method, the last in first out (LIFO) method, and the first in first out

(FIFO) method.

allowed inventory costing method, however, it is an allowed method under GAAP.

There has been a push in the last decade or so for IFRS and GAAP to converge into one

set of universal standards. With the continuing increase in globalization, it is believed that

American companies will have to eventually adopt IFRS in order to remain in the international

market (Sedki, Smith, & Strickland, 2014). If the standards were to be converged, then LIFO

would likely no longer be an option for companies to use (“Investopedia stock analysis: How

does inventory accounting differ between GAAP and IFRS?”, 2015). If LIFO were to be

eliminated companies that switched over to FIFO may have immediate additional tax liabilities