Industry Insight: Inventory Valuation
InventoryInventory includes all of the costs incurred in purchasing merchandise and preparing it for sale, including raw materials, direct labor and manufacturing overhead. Even after merchandise is sold, it may still be included in the seller's inventory. If the seller bears the shipping costs – freight on board (FOB) destination – then the seller owns the merchandise from the time it is shipped until it is delivered to the buyer. Goods that are FOB shipping point are the buyer’s property and consigned goods belong to the consignor.
Accounting and CostingThe primary methods of accounting for inventory are periodic and perpetual. In a periodic inventory system, sales are recorded as they occur, but the inventory and cost of goods sold are not adjusted. At the end of each period, inventory is physically counted to determine ending inventory. Inventory and cost of goods sold are then adjusted to actual based on the physical count.
The most common inventory costing methods are first-in, first-out (FIFO); last-in, first-out (LIFO); and average cost or weighted average cost. FIFO matches the older costs with revenues and results in a more realistic inventory valuation on the balance sheet. LIFO matches the most recent costs with current revenues, producing a more realistic income statement. Table I shows the effect on the balance sheet and income statement for each costing method:
During periods of rising inventory costs, cost of goods sold is highest with LIFO and lowest with FIFO. As such, gross profit, net income and ending inventory are lowest with LIFO and highest with FIFO.
The assumed flow of goods for costing purposes does not have to match the actual physical movement of goods. For example, a grocery store tries to sell the oldest units first to minimize spoilage. The physical flow of goods is on a FIFO basis, but the company could use FIFO, LIFO or average cost in determining ending inventory for financial and tax purposes. Lower of Cost or MarketInventory is generally valued at cost. However, if inventory is damaged, used or obsolete it should be reported at its net realizable value (selling price less estimated selling costs). When inventory can be purchased new at an amount that is less than its original cost, inventory should be written down to the lower of cost or market. The ceiling, or maximum, market amount at which inventory can be carried on the books is equal to the net realizable value. The floor is the net realizable value minus a normal profit. Any reductions in inventory value are expensed in the current period.
Inventory costing and valuation have a direct impact on the assets and net income of the company. It is important to evaluate the different options and select the methods which accurately reflect the company's operations and leverage any potential income tax benefits.