Inventory accounting
Which cost gets attached to the thing you just sold. The answer changes reported profit, reported tax, and how quickly you find out that demand fell.
A shop buys identical widgets three times at rising prices, then sells one. Which purchase price is the cost of that sale? The widgets are indistinguishable, so the answer is a policy choice — and the choice moves profit.
The two main conventions
Purchases: one widget at $10, then $12, then $14. One widget sells for $20.
FIFO (first in, first out) assigns the oldest cost, $10. Gross profit $10, and remaining inventory is carried at $12 + $14 = $26.
LIFO (last in, first out) assigns the newest cost, $14. Gross profit $6, and remaining inventory is carried at $10 + $12 = $22.
Same shop, same widgets, same sale. Reported profit differs by 40%.
FIFO reports higher profit when costs are rising, and leaves inventory on the balance sheet closer to current prices. LIFO reports lower profit when costs are rising — and therefore lower tax — while leaving inventory recorded at stale, understated costs.
This is one of the larger genuine obstacles to comparing a US company with an international peer. A US filer using LIFO discloses the LIFO reserve — the difference between the two methods — which lets you convert. It is in the footnotes.
Inventory cannot be carried above what it will fetch
Both systems require inventory to be written down when its value falls below cost — unsold fashion, superseded electronics, perished food. The write-down hits profit in the period it is recognised, not the period the goods were bought.
The signal investors actually use
Inventory turnover = cost of goods sold ÷ average inventory. It answers how many times a year the shelves empty and refill.
Goods accumulate for one of two reasons: management expects demand that has not arrived, or demand has already fallen and production has not adjusted. Both end the same way — discounting, which cuts margin, or write-downs, which cut profit. The inventory line moves before either shows up in earnings.
The mirror-image trick
Inventory can also be used to flatter profit. Manufacturing overheads are attached to units produced, not units sold, so building more units than you sell moves cost from the income statement onto the balance sheet. Reported profit rises. The cost has not vanished; it is sitting in a warehouse waiting to be recognised.
The tell is production exceeding sales while margins improve. Cash flow will not corroborate the improvement, because cash went out for the goods and never came back. See working capital.
Where it barely matters
Software, services and most financial businesses hold essentially no inventory. For retailers, manufacturers, distributors and carmakers it is often the largest current asset and the fastest-moving indicator of whether the next quarter will disappoint.