INVENTORY ACCOUNTING: Valuation Methods, Adjustments, Financial Statement Effects

Graziano Stefanelli
Jun 5
2 min read

Inventory accounting determines how costs of goods held for sale are measured, recorded, and reported. It directly affects cost of goods sold, gross profit, net income, and asset valuation.

1. What Is Inventory?

Inventory consists of goods held for sale, in production, or used in producing other goods.

It includes:

Raw materials
Work-in-progress (WIP)
Finished goods

Only inventories intended for sale or use in operations qualify as assets.

2. Inventory Valuation Methods

Inventory costs can be allocated using several accepted methods, each with different income effects.

Method	Description	Best Used When
FIFO	Oldest costs assigned to COGS, newest to ending inventory	Rising prices (shows higher profits)
LIFO (US only)	Newest costs assigned to COGS, oldest to ending inventory	Inflationary periods (tax benefit)
Weighted Average	COGS and inventory based on average cost per unit	Homogeneous or interchangeable items
Specific Identification	Actual cost tracked per item	High-value, unique items (e.g., vehicles)

Note: IFRS does not permit LIFO; only FIFO, weighted average, and specific identification are allowed.

3. Recording Inventory Purchases

Inventory is recorded at cost, including:

Purchase price
Import duties and freight
Handling, storage, and preparation costs

Journal entry on purchase:

debit Inventory
credit Accounts Payable or Cash

Example

Purchased raw materials for $15,000:

debit Inventory ......................................... 15,000
credit Accounts Payable ................................ 15,000

4. Cost of Goods Sold (COGS)

COGS = Beginning Inventory + Purchases – Ending Inventory

Inventory methods determine which costs are used when inventory is sold.

Example (FIFO):

Beginning Inventory: 100 units @ $10
Purchases: 100 units @ $12
Sale: 150 units
FIFO COGS = (100 × $10) + (50 × $12) = $1,000 + $600 = $1,600

5. Inventory Adjustments

Adjustments ensure reported balances reflect reality.

Common adjustments include:

Shrinkage: Physical count < recorded balance
Obsolescence: Unsellable or outdated items
Lower of Cost or Market (LCM): Valuation floor under GAAP
Net Realizable Value (NRV): IFRS equivalent to LCM

Entry to write down inventory:

debit Loss on Inventory Write-Down
credit Inventory

6. Financial Statement Impact

Balance Sheet: Inventory reported under current assets, net of allowances.
Income Statement: COGS reduces gross profit. Inventory write-downs also hit expenses.
Cash Flow Statement: Inventory purchases and changes impact operating activities (indirect method).

Example

If inventory increases during the year, it’s shown as a cash outflow in the operating section.

7. Inventory Turnover and Days in Inventory

Key metrics to assess inventory efficiency:

Inventory Turnover = COGS ÷ Average Inventory
Days in Inventory = 365 ÷ Inventory Turnover

High turnover implies strong sales or low stock; low turnover may signal overstocking or obsolescence.

8. Periodic vs Perpetual Systems

System	Description	Pros/Cons
Perpetual	Updates inventory records continuously	Accurate but costly to implement
Periodic	Updates only at period-end via physical count	Simpler but less timely

Key take-aways

Inventory accounting determines how product costs affect profits and asset values.
FIFO, LIFO, and weighted average each have different financial impacts.
Adjustments like shrinkage and obsolescence ensure realistic reporting.
Turnover ratios and inventory aging help optimize supply and liquidity.

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