The Rules for Inventory Accounting
For many small businesses, inventory makes up a large portion of the company's balance sheet. Inventory rules may seem complex, but they boil down to a short list of key principles. Understanding the principles that inventory accounting are based on can help you make sure that inventory is accounted for properly in your small business.
Inventory accounting rules have strict guidelines on the physical goods that can be included in the inventory count. The key to these rules is to determine who has legal title to the goods on the date that the financial statements are issued. For example, a company may have goods on consignment with other retailers, share warehouse space with another company or have goods that are in transit. If title has transferred to the company for those goods, they should be reflected in the company's inventory; otherwise, they must be excluded.
Manufacturing companies must be aware of the rules that determine whether costs are considered product costs, which must be included in inventory, or period costs, which must be excluded from inventory. In general, costs that can be traced to products, such as materials, labor and factory overhead costs are considered to be product costs and are capitalized into the company's inventory. Other costs, such as general, selling and administrative costs are period costs and must be excluded.
A company's cost flow assumption determines the manner in which goods enter and leave the company's financial inventory records. For example, the LIFO cost flow assumption assumes that the last item of inventory to be recorded is the first one to be sold, whereas the FIFO system assumes that the first item recorded is the first to leave. The cost-flow assumption chosen by a business does not have to match the actual flow of goods. In most cases, small-business owners choose the FIFO cost-flow assumption, because it is generally simpler to account for. For companies that sell goods that are highly differentiable, the specific identification assumption may be a good choice. This cost-flow assumption tracks each individual item of inventory and accounts for product movement on that basis.
The rule for the valuation of inventory is that it must be held in the accounting records as the lower of cost or market. This implies that if the value of inventory on hand is lower than either what a company paid for the inventory or the inventory's market value, then the inventory should be written down in the company's records. Small-business owners should exercise caution, because the market value reference in the lower of cost or market rule can be confusing. Under generally accepted accounting principles, market value is defined as the "middle value" of replacement cost, net realizable value and net realizable value less a normal profit margin.