When Does the Cost of Inventory Become an Expense?
Understand the accounting principles that transform inventory from an asset to an expense, ensuring costs are correctly recognized when a sale or value loss occurs.
A product’s journey from a warehouse to a customer involves an accounting transformation where its cost shifts from a company asset to an expense. This transition is important for measuring profitability. The timing of this change is governed by accounting rules designed to accurately reflect a company’s financial performance.
Inventory as an Asset on the Balance Sheet
Items a company holds for resale are recorded on its balance sheet as inventory, a current asset. This is because the business expects to sell these goods for cash within one year or its operating cycle. The value of this asset includes the purchase price plus other costs necessary to get the inventory ready for sale.
Under U.S. Generally Accepted Accounting Principles (GAAP), these capitalized costs include freight-in, handling fees, and insurance during transit. Import duties or non-refundable taxes are also added to the inventory’s cost. Capitalizing these expenditures means the company delays recognizing the cost as an expense until the product generates revenue.
The Transition to an Expense Cost of Goods Sold
The moment inventory’s cost shifts from an asset to an expense is at the point of sale. When a customer buys a product, the company recognizes revenue on its income statement. At the same time, the cost of the item is transferred from the inventory asset account to an expense account called Cost of Goods Sold (COGS).
This timing is dictated by the matching principle, which requires that expenses be recorded in the same period as the revenues they helped generate. Matching COGS against sales revenue allows a company to accurately calculate its gross profit. This provides a clear picture of the profitability of its operations.
Determining Which Costs to Expense Inventory Costing Methods
When a company buys identical inventory items at different prices, it must use a system to determine which cost to move to COGS upon a sale. GAAP allows for several inventory costing methods for this calculation. The chosen method impacts the reported values of COGS and the remaining inventory.
The First-In, First-Out (FIFO) method assumes the first units purchased are the first sold. In a period of rising prices, FIFO results in a lower COGS and higher reported net income. The Last-In, First-Out (LIFO) method assumes the most recently purchased items are sold first, which during inflation results in a higher COGS and lower taxable income.
Another option is the Weighted-Average Cost method, used when tracking individual items is difficult. This approach calculates the average cost of all goods available for sale and applies that average to the units sold. The method smooths out price fluctuations, providing a COGS value between FIFO and LIFO.
Expensing Unsold Inventory Write-Downs
Inventory costs can also become an expense without a sale. If the value of inventory drops below its recorded cost while in stock, a company must recognize the loss. This can happen due to damage, spoilage, obsolescence, or a decline in market prices, and the process is called an inventory write-down.
The GAAP rule for write-downs depends on the company’s costing method. For inventories using the FIFO or average cost methods, valuation is at the lower of cost or net realizable value (NRV). NRV is the estimated selling price less predictable costs of completion and disposal.
For inventories using the LIFO or retail methods, valuation is at the lower of cost or market. Here, “market” means the current replacement cost, but this value is capped by NRV and floored by NRV less a normal profit margin.
If an inventory’s carrying value is reduced, the write-down amount is recognized as an expense on the income statement, often as part of COGS. This action reduces the company’s reported profit for that period.