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With supply chain challenges and increasing inflation wreaking havoc on the cost of inventory, business leaders might be looking to better understand their own inventory costing methods and whether they should make a change. However, it is important to know the answers to a few key questions prior to making any change to your business's inventory costing method.
A company must adopt an inventory costing method that should be applied consistently each year (certain requirements exist when changing inventory costing methods; see additional information in considerations #2-4 below). The main inventory costing methods allowable by Generally Accepted Accounting Principles (GAAP) are the following:
There are additional allowable inventory costing methods, such as the retail method or specific-identification method; however, the methods above are the mostly commonly utilized.
Another inventory costing method that is commonly used is standard costing, but the standard costing method is not actually an inventory costing method recognized by GAAP. However, the standard costing method is considered acceptable if the standard costs are adjusted such that the cost of inventory at standard cost reasonably approximates the cost of inventory under one of the recognized methods listed above. In order to help ensure that this is the case, a company must update the standard costs within its inventory system on a regular basis. This is especially important when prices are fluctuating significantly. When standard costing is used, language must be included in the financial statement disclosures such as "inventory costs are determined using standard costs, which approximate average costs."
Below is a brief description of the main costing methods recognized by GAAP:
The FIFO method assumes that the first goods purchased are the first goods sold out the door. One of the pros to using FIFO is that it generally follows the actual physical flow of goods through the company. In an environment where costs are increasing, this means that the oldest (lowest) cost items are getting matched up with the current (higher) sales prices.
One con to using FIFO is that this results in higher net income, and, ultimately, higher taxes generally need to be paid.
The LIFO method assumes that the last goods purchased are the first goods sold out the door. One of the pros to using LIFO is that when prices are increasing, the higher current costs are being matched against the higher current sales prices. This generally results in a lower net income and a lower current tax bill.
However, the accounting for inventory at LIFO can be more complicated as the older "layers" of goods (typically at a lower cost) remain in inventory and get carried forward until they are liquidated. As these older layers get liquidated, the lower costs are matched against the higher sales prices, resulting in higher net income and taxes.
The weighted average/average costing method calculates an average cost of the goods in inventory and applies that on a per-unit basis.
It is important to note that the inventory costing method that a company selects for recording inventory does not need to reflect the actual flow of goods. The costing method is simply used for accounting purposes.
Once you decide that you are ready to make a change in your company's inventory costing method, you must then determine how to record that change in the system.
First of all, there are certain financial statement disclosures required during the year of the method change (see consideration #3 below). Therefore, while implementing the change within your inventory or accounting system, it may be easiest to track changes specifically related to the method change in a separate account (i.e., inventory adjustment account). Generally, this account will be included in Cost of Goods Sold (COGS) within your trial balance for tracking purposes.
Let's look at an example:
Example: A company is switching from FIFO costing to standard costing. There are 1,000 units in inventory, and under FIFO, there are 500 units at $5 and 500 units at $7. This results in total inventory cost under FIFO of $6,000. The standard cost for this item is going to be $5 in the system. Once updated in the system, total inventory cost under standard cost will only be $5,000.
The $1,000 difference recorded when this costing change is entered into the system would be debited and tracked in your inventory adjustment account during the year.
At the end of the year, that account would reflect the cumulative impact of the change in the inventory costing method. You would then need to evaluate that impact and, if it is significant, allocate a portion of the impact as part of your ending inventory balance.
First, the inventory accounting policy footnote would need to be updated to correctly disclose the new basis of the inventory costing.
Second, a change in the inventory costing method is considered a change in accounting principle. For any significant change in accounting principle, GAAP requires certain disclosures to be included in the financial statements, as well as a modification of the report of independent auditors. These disclosures should describe the nature of the change, as well as explain why the newly adopted principle is preferable.
Whenever the change has created an inconsistency among the years being presented, the effect of the change on the income statement must be disclosed. In addition, the method of applying the change should be disclosed.
GAAP generally requires that a change in accounting principle be reported through retrospective application, unless impracticable or the cumulative impact is clearly immaterial to the financial statements. When the new accounting policy is applied retroactively, required disclosures include:
These disclosures are only required to be included in the financial statements during the year that the change is implemented — not during subsequent years.
In the example above, the new standard costing approach is presumed to approximate the FIFO method, and therefore no retroactive financial statement adjustments would be required. However, if you changed from FIFO to LIFO, an analysis would be required to estimate the cumulative effect of the change on your opening equity balance.
As with any GAAP principle, it is important to consider the materiality of the change to the financial statements as a whole. If the change in inventory costing method is not material to the financial statements, then no disclosure of the change would be required by GAAP. However, it is important to know the total impact of the change to be able to conclude that the change was not material.
Above, we discussed the accounting and financial statement impacts due to the change in accounting method. But there are additional tax impacts that business leaders should consider as well.
If the LIFO method is used for tax purposes, then it is required to also be used for GAAP. Consistency between tax and GAAP is generally not required with the other inventory costing methods. While income tax regulations for inventory accounting generally conform to GAAP, and in many cases provide a high degree of latitude for small businesses, the IRS has the ultimate authority to prescribe the best method to clearly reflect income. Businesses with average revenues exceeding $27 million, along with certain companies reporting losses, with more than 35% allocated to passive owners, are subject to more stringent inventory accounting rules. A detailed discussion of these rules, found in code sections 471 and 263A, as well as their related regulations, is beyond the scope of this discussion.
Any change to your method of accounting for inventory costing requires approval from the Internal Revenue Service (IRS). Therefore, a Form 3115 must be filed with your tax return. In addition, the difference between the inventory cost under the new method and inventory cost under the old method would need to be disclosed as of the date of the beginning of the tax year in which the change occurred. For example, if the change in method was implemented in the summer of 2022, the difference in inventory costs would be presented as of January 1, 2022. This is similar to how the change is applied retroactively for GAAP purposes above.
When a method change is filed for tax purposes, most often it requires a 481(a) adjustment, which reflects the effect of the change as of the beginning of the year. Generally, it does not make any practical difference how much the adjustment needs to be, as it would be the same whether recorded at the beginning versus the ending of the year. However, if the beginning-of-year change results in a net increase to taxable income, the 481(a) adjustment can be spread over four years instead of being entirely reflected in the current year.
Example: Finishing with the example from above, the overall impact of the change in the costing method was $25,000. Therefore, this would be the amount reported as the 481(a) adjustment and on the Form 3115 at the beginning of the year.
There are many factors to consider when deciding whether it is a good idea to make a change in your method for determining inventory cost. Please reach out to our Delap experts if you have any questions or would like to further discuss any of the pros and cons of making a switch.