How to track inventory: FIFO vs average cost, and when to adjust stock

Perpetual or periodic

There are two ways to keep track of stock.

• Periodic: purchases go straight to an expense or purchases account, and you count the stock at the end of the period. Cost of goods sold = opening stock + purchases − closing stock. It is simple, but you only know your margin when you count.
• Perpetual: every purchase adds to an inventory asset and every sale moves its cost into cost of goods sold right away. You always know what is on the shelf and what each sale earned. Accounting software does this for you.

Even with perpetual records you still count. The IRS says that with a perpetual inventory you must take a physical inventory at reasonable intervals and adjust the books to agree with it (Publication 538). Theft, breakage and miscounts happen whatever the software says.

FIFO vs average cost, worked through

When you buy the same item at different prices, you need a rule for which cost goes with each sale. Two rules cover most small businesses:

• FIFO (first in, first out): the oldest cost is used first.
• Average cost: every unit on hand carries the same average cost, recalculated each time new stock arrives at a different price.

One item, one month:

FIFO. The first sale uses 60 units at $10 = $600. The second uses the 40 remaining $10 units ($400) and then 50 of the $12 units ($600), for $1,000. Cost of goods sold is $1,600. The 50 units left are valued at $12, or $600.

Average cost. The first sale is at $10 = $600, leaving 40 units worth $400. The March 15 purchase brings it to 140 units worth $1,600, an average of $11.43. The second sale costs 90 × $11.43 = $1,028.57. Cost of goods sold is $1,628.57. The 50 units left are worth $571.43.

The total cost is the same. The methods only change which period gets it. When prices are rising, FIFO shows slightly lower cost and higher profit now, and a closing inventory nearer to today's prices. Average cost smooths out price swings. For most small businesses the difference is small, and staying consistent matters far more than which method you pick.

For transparency: AcboBooks values inventory at average cost, recalculated as stock comes in. It does not do FIFO. If your accountant needs FIFO for a return, ask how they want the year-end figure adjusted.

What the IRS and CRA allow

United States

• Publication 538 lists specific identification, FIFO and LIFO as ways to identify the cost of items in inventory. Your method must clearly reflect income and be consistent from year to year.
• A rolling-average method that you use in your financial statements is treated as clearly reflecting income if it meets the safe harbours in Revenue Procedure 2008-43. The average must be recalculated at least monthly, and either your ending inventory stays within 1% of its FIFO cost or your inventory turns over at least four times a year.
• Changing your inventory method is a change in accounting method. It needs Form 3115, and some changes qualify for automatic approval.
• Small business taxpayers (average gross receipts of $31 million or less, indexed for inflation) have simpler options, including not keeping a formal inventory for tax. Ask your accountant whether that applies to you.

Canada

• The CRA's guidance names specific item, average cost and FIFO as the common cost methods. LIFO is not accepted for income tax.
• You value inventory either at the lower of cost and fair market value for each item, or all at fair market value, using the same method as in past years.
• A change of cost method is accepted only if the new method is more realistic and gives a truer picture of income. In practice, choose once and stick with it.

Counts, shrinkage and damaged stock

A count compares what is on the shelf with what the books say. The difference is an adjustment, posted to a shrinkage or inventory adjustment account that sits in cost of goods sold.

Following on from the example: the books show 50 units at $11.43. The count finds 47. The three missing units cost 3 × $11.43 = $34.29:

Damaged or obsolete stock that you still hold but cannot sell at cost is a value adjustment, not a quantity one. Write it down to what it is worth. If 10 units are water-damaged and will sell for $4 each, reduce their value from $114.30 to $40.00 and post the $74.30 to the same adjustment account.

In the US, inventory losses from theft or casualty normally go through cost of goods sold this way. You cannot also claim them as a separate casualty loss (Publication 538). Insurance money you receive for the loss is income.

In AcboBooks, print the Physical Inventory Worksheet for your counters. Then enter the counted quantities in Adjust Inventory, which posts the difference at average cost. For damaged stock, enter a new value instead.

Habits that keep stock right

• Count fast movers often. A short cycle count of the top items each month catches problems early. Do a full count at year-end.
• Receive stock in the system the day it arrives, even before the bill comes, so quantities never go negative.
• Record returns and samples, not only sales. Unrecorded giveaways look exactly like theft.
• Investigate large adjustments. A missing $34 is shrinkage. A missing $3,400 is a process problem.

The inventory review belongs in your month-end routine. See the monthly closing checklist and, for retailers, accounting software for retail.