Lesson 66 - Beginner accounting course

66. Introduction to Inventory Accounting Methods

Inventory is one of the most valuable assets for businesses that sell physical products. Proper inventory accounting ensures accurate financial reporting and helps businesses make informed decisions about pricing, purchasing, and profitability.

1. What is Inventory Accounting?

Inventory accounting tracks the value of goods a business holds for sale. It impacts:

✔ Financial Statements – Determines the cost of goods sold (COGS) and net income.
✔ Taxation – Affects taxable income based on how inventory is valued.
✔ Cash Flow Management – Helps businesses plan purchases and avoid overstocking.

2. Types of Inventory 

3. Inventory Accounting Methods

Businesses use different methods to track inventory costs, which can impact financial results. The three most common methods are:

A. FIFO (First-In, First-Out)

• The oldest inventory items are sold first.

• Best for: Industries where products expire (e.g., food, medicine).

• Effect: Results in lower COGS during inflation, increasing profits.

B. LIFO (Last-In, First-Out)

• The newest inventory is sold first.

• Best for: Businesses aiming to reduce taxable income during inflation.

• Effect: Results in higher COGS and lower reported profits.

C. Weighted Average Cost (WAC)

• Averages the cost of all inventory items.

• Best for: Businesses with identical or interchangeable products.

• Effect: Smooths out price fluctuations over time.

4. Choosing the Right Inventory Accounting Method

Businesses select an inventory method based on:
✔ Industry Requirements – Food and medical industries often use FIFO.
✔ Tax Considerations – LIFO reduces taxable income in inflationary periods.
✔ Financial Reporting Goals – FIFO shows higher profits, which may attract investors.

Understanding these inventory methods helps businesses optimize profits, reduce tax burdens, and maintain accurate financial records.