Inventory represents goods the company plans to sell its customers. Depending on the nature of the firm’s operations, inventories can include raw production materials, work in process, finished goods, and/or merchandise inventory. The balance in this account is also affected by accounting decisions.
Accounting standards permit various acceptable inventory measurement methods, including last-in-first-out (LIFO), first-in-first-out (FIFO), weighted average, and specific identification. Specific identification has been used most frequently for inventories in which the separate items are distinct and have a high cost, such as fine jewelry, because the benefit to be gained from tracking these individual items is high. For lower-cost items in inventory, the value of such specific tracking is low unless a company is using powerful digital databases that allow detailed inventory tracking to be readily and cheaply accomplished.
Even if a company uses sophisticated technology to control inventory, the accounting measures do not have to reflect precise physical flows, as would occur using specific identification. Rather, the LIFO, FIFO, and weighted average methods refer to assumptions that are made about the flow of inventory through the company. Using FIFO, the company assumes that the first goods sold are the oldest and the most recently acquired items remain in inventory on the balance sheet. Using LIFO, the costs of the oldest inventory are maintained on the balance sheet under the assumption that the most recently acquired inventory is sold first. The weighted average method uses average costs over the reporting period to calculate the inventory balance. The effect of accounting choices on the income statement and balance sheet is presented below.Accounting, Financial Statement Analysis, Fundamental Analysis See also: