How Inventory Valuation Affects the Financial Statements
In accounting, you’re preparing financial statements for users outside the business, such as investors and lenders. They need accurate financial statements to make informed decisions on whether they want to invest in the company or loan it money.
Comparing merchandising and manufacturing companies
For manufacturing companies (which make products) and merchandising companies (which sell the products made by the manufacturers), inventory can be a big part of the balance sheet. Along with accounts receivable, inventory may be the largest current asset account. So proper accounting for inventory is important, and that includes the value placed on ending inventory.
A company can inadvertently prepare a set of highly inaccurate financial statements by expensing purchases rather than keeping them on the balance sheet as inventory (an asset account).
So which costs are okay to expense directly on the income statement, and which costs should stay on the balance sheet as assets? Here’s a quick and dirty answer: Any item that a company buys for eventual sale to a customer should be recorded as inventory, which appears on the balance sheet.
Connecting inventory to revenue
Inventory ties into both the revenue process and the cost of goods sold. Associating inventory with cost of goods sold makes common sense — you have to buy something before you can sell it. But you may be wondering how revenue and inventory relate to each other.
Well, remember that you need to use generally accepted accounting principles (GAAP). GAAP’s matching principle dictates that expenses are matched with revenue earned for the period.
How does inventory come into the revenue equation? You need to compute cost of goods sold for both a merchandising and a manufacturing company. Consider this process:
Product costs are any costs that a company incurs when purchasing or manufacturing an item for sale to customers. Product costs are part of inventory (an asset account).
When a sale occurs, product costs are posted to cost of goods sold (an expense account).
Any product costs for unsold inventory remain in the inventory (asset) account at the end of the period.