GAAP requires companies to physically count their inventories at least annually. So, for year-end financial statements filed with the Securities and Exchange Commission (SEC), inventory reported is based on physical counts.
But, companies must also report financial statements on a quarterly basis. For example, for a company who has a year-end on December 31st, in addition to reporting December 31st financial statements, the company must also report quarterly financial statements on March 31st, June 30th, and September 30th. GAAP doesn't require physical counts for the March 31st, June 30th, and September 30th financial statements. So, how is inventory estimated for these periods?
The gross profit method estimates ending inventory value using information that is known from availableĀ accounting records: cost of goods available for sale and cost of goods sold.
Companies always know the value of their beginning inventory from the previous year's end of year physical inventory count. In addition, manufacturing costs (for a manufacturer) or purchase costs (for a non-manufacturer) are easily tracked during the year by a company's accounting system. The same is true for the cost of goods sold during the year. So, the equation above, can be re-written to obtain an estimate of ending inventory for quarterly financial statements.
The key to obtaining good estimates is having a reliable estimate of the gross profit ratio (40% in the example above).