Understanding the Accounting Implications of Inventory: Why Proper Valuation Matters

Looking to understand which inventory method best to use for your business? It is important to think about this clearly before making any rash decisions, because correct inventory valuation methods and recording of inventory discrepancies can significantly impact key financial metrics. 

Cost of Goods Sold

Let's first look at the cost of goods sold and what it is. Cost of Goods sold refers to an item on the income statement that is deducted from revenue. It is the total amount a company has spent on inventory during an accounting period that it sold to customers. 

To calculate COGS, you would need to know the purchase price of inventory and the time of the purchase. Then, you need to apply an inventory method suited to and allowed by the relevant accounting standards of your country.

For example, in many jurisdictions, either FIFO or the weighted-average cost formula is possible.

Net income

Net income is the bottom line of a business, the profits a business made in a defined accounting period, after tax. 

For example, you would need to deduct COGS from revenue and then subtract SG&A (selling, general, and administrative expenses), operating costs, depreciation and amortization, interest expenses, taxes, and other expenses. 

In simple terms: 

Balance Sheet Health

A healthy balance sheet can be measured in different ways; when looking at working capital, inventory valuation plays a crucial role. Working capital includes all operating assets and liabilities of a company, including accounts payable and receivable, inventory, short-term investments, and short-term debt. 

Working capital management is important because balanced working capital means the company is able to operate without funding operations by issuing debt or equity. 

For proper working capital management, it is also important that inventory is valued correctly, because otherwise, it may create a sense of healthiness of a company that may not be entirely accurate. 

Several key ratios are important to understand if a company has a healthy working capital:

• Working Capital Ratio: (Net) working capital is the total of current assets minus current liabilities. Positive working capital shows that the company’s liquidity position is healthy because there is a higher amount of current assets on the balance sheet compared to current liabilities.
• Current Ratio: The current ratio divides current assets by current liabilities. A current ratio above 1 indicates a healthy position, while a current ratio below 1 indicates a position where the company needs to keep financing its working capital.   
• Quick Ratio: The quick ratio only takes a company’s most liquid assets such as cash, cash equivalents, marketable securities and accounts receivable in account and devides this sum by total current liabilities. The quick ratio omits inventory, thereby a quick ratio above 1 indicates that the company is able to pay all its short term obligations by selling the most liquid assets it has, without needing to touch its inventory.

To sum up, positive working capital means a current ratio above 1. A quick ratio above 1 indicates that the company is able to meet short term obligations even without the need of selling inventory.

Inventory valuation methods

Generally speaking, there are three different ways to value inventory, and they all have their different advantages and disadvantages:

• FIFO (First-in-First-Out)
• LIFO (Last-in-Last-Out)
• Weighted-Average Cost

LIFO Method

LIFO stands for 'Last-In-First-Out' and refers to the latest purchased inventory removed when a sale occurs. The advantage of LIFO is that it most accurately reflects the current market prices for inventory. 

Weighted-Average Cost Method

With the weighted-average cost method, the prices and quantities of inventory purchases are weighted to arrive at a weighted-average price, which is used to value the whole stock of inventory. The advantage is that it accurately reflects the true cost a business had to bear when acquiring inventory. 

FIFO Method

FIFO stands for ‘First-In-First-Out’ and refers to the oldest inventory getting sold first. So, for example, if prices to purchase the relevant items have been rising over time, there may still be a profit for the business in accounting terms, even though when using LIFO for the same transaction may record a loss.

Regardless of the method you’re choosing for managing and valuing your inventory, keep in mind that it needs to be both suitable for your business and permitted under your country’s accounting standards. 

Inventory discrepancies

Inventory discrepancies can be discovered during normal business operations or during a stock audit. It means that a difference between actual inventory and inventory recorded in the ledger is noticed, which can affect COGS and other financial ratios. 

Typically, the following cases are responsible for inventory discrepancies: 

Theft or Loss

Theft or Loss is removal of inventory that has been already entered into the ledger, for example due to accidental loss. The missing inventory causes inventory levels on the ledger to be overstated, which needs to be corrected. 

Damage

If goods get damaged, they can typically not be resold. Different to theft or loss however, the damaged units are present physically and in the inventory system, but they can’t be sold. Hence, also this causes the inventory value to be overstated and needs to be corrected.

Errors in Counting/Recording

Errors in recording inventory or counting can easily happen for example if an employee misses to count items, double counts SKUs or a system records wrong data. It can affect inventory valuations in both directions: inventory values can either be overstated, if more units have been counted and entered into the ledger than units are present, or understated, when the reverse occurred. 

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