Inventory or stock is the goods and materials that a business holds for the ultimate purpose of resale (or repair), and inventory management is a science that specifies the shape and percentage of stocked goods. Inventory could be in the form of raw materials, work in progress, or finished or completed goods.

Since inventory is an important part of any business, its management can affect any of the financial statements. For instance, a low inventory level could lead to delays in deliveries, while an excess in stock could adversely affect your cash flow.

Different Methods of Accounting for Inventory

Your chosen method of valuing inventory is indicated as the inventory footnote on your financial statement. The best-known methods for valuing inventory are:

FIFO: The first-in-first-out (FIFO) method usually yields a higher gross profit, higher taxable income, and lower cost of goods sold (COGS) due to higher ending inventory.
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LIFO: The last-in-first-out (LIFO) method does just the opposite wherein everything would be higher except the COGS. The COGS is an expense and will be subtracted from the income in the income statement. The equation used to calculate COGS is: Cost of Goods Sold = Beginning Inventory + Purchases or Goods Available – Ending Inventory. Generally, small businesses prefer the LIFO method. This is because, during periods of growth, the method yields lower income and income tax payments, thereby enhancing the firm’s cash flows.

An inventory is most often listed as a current asset on financial statements. Therefore, the way you value inventory would determine the total current assets, total asset balances, and the actual inventory itself. When you sell, COGS increases and it is shown as an expense on your statement. Another important point is that financial statements need to be error-free – an erroneous inventory can lead to several errors in your financial statements. The COGS, profits, and net income can be incorrect.

4 Ways in Which Inventory Management Affects Financial Statements

1. The Income/Profits:

If there are any errors in calculating inventory, there would be cascading effects on COGS, profits, and income. There are several reasons why your inventory might be inaccurate. Some instances include breakage during transit, not adding returned goods to inventory, and old goods which might have to be sold at a discount. In all such cases, you need to adjust your inventory to an accurate value. Understand that using LIFO will have higher COGS and would be more representative of the current economic reality. Hence, profitability will be more accurate, making it a better indicator for forecasting.

Adjusting inventory cannot be an annual affair. This should be done more often so that there are no major changes to the inventory value during the time of change. For this, companies often use an inventory reserve account, where obsolete or unusable inventory is recorded as a percentage of the inventory value. The inventory reserve account is a balance sheet account and would have a negative balance. If you pit it against the inventory account, you would get an accurate idea of your inventory. Deloitte in its article Financial statements: Framing your judgment calls states that Equipped with a formal framework, finance chiefs can help avoid once-in-a-lifetime events that could sideline a company or cost heavily in terms of time, reputation, and at worst, regulatory scrutiny, fines, and restricted access to capital.

2. Cash Flows:

If a business uses FIFO when prices are rising and inventories are also rising, COGS would be low and net income would be higher. As a result, the company would have to pay higher taxes. This would result in a lower cash flow for the firm.

3. Balance Sheet:

Changes in inventories and incorrect inventory balances affect your balance sheet, the financial statement that is a snapshot of your company’s worth based on its assets and liabilities. An incorrect inventory balance can result in an inaccurately reported value of assets and owner’s equity on the balance sheet. However, it does not affect liabilities.

4. Working Capital:

Since working capital is defined as current assets minus current liabilities, when inventory goes up in the income statement, the working capital would also go up.

In conclusion, it is important to ensure that the inventory shown in your financial statement is accurate. Understand that keeping your inventory from being too high or too low can help you to make better financial forecasts.