Inventory is reported as a current asset and is often listed after receivables on a balance sheet. In addition to showing the inventory amount, a business must disclose the costing method used to value inventory (specific identification, FIFO, LIFO, or average cost) and the application of LCM. This disclosure helps a business adhere to the full-disclosure principle.
The full-disclosure principle requires that a company’s financial statements report enough information for outsiders to make knowledgeable decisions about the company. To provide this information, accountants typically include a set of footnotes that accompany the financial statements.
Footnote disclosures help ensure that companies report relevant, reliable, and comparable financial information. A common footnote related to inventory would look like this:
NOTE 2: Statement of Significant Accounting Policies:
Inventory. Inventory is carried at the lower of cost or market. Cost is determined using the first-in, first-out method.
Suppose a banker is comparing two companies, one that uses LIFO and the other, FIFO. When inventory costs are rising, the company using the FIFO inventory costing method reports higher net income, but only because it uses FIFO. Without knowledge of the accounting methods the companies use, the banker could lend money to the wrong business or lend the wrong amount of money to each.
Inventory Shrinkage
Inventory shrinkage represents a loss of inventory and is most often the result of employee theft, customer theft, or the damage, spillage, or spoilage of inventory items.
The perpetual inventory method keeps a continuous record of the inventory on hand at all times. However, the actual amount of inventory on hand may differ from the amount on hand according to the accounting records as a result of errors in recording inventory-related transactions or as a result of inventory shrinkage.
Physical Inventory Count
A physical inventory count is used to determine the amount of inventory actually on hand at the end of the accounting period. A count usually occurs when a store is closed.
The inventory value derived from the physical inventory count is used as the Inventory account balance on the balance sheet. The accounting records are adjusted for any difference between the inventory value determined by the count and the value according to the perpetual records.
The Inventory account is debited or credited as necessary, with a corresponding credit or debit to the Cost of Goods Sold account.