Inventory Valuation

Inventory valuation is the process of determining the monetary amount at which a business reports the goods it holds at the end of an accounting period. Because the cost of goods available for sale must be split between goods sold and goods still on hand, the value assigned to ending inventory directly determines cost of goods sold, gross profit, taxable income and the inventory figure on the balance sheet. An error of $1 in ending inventory changes profit by $1 in the same direction.

Inventory valuation involves two main steps: measuring cost, which requires choosing a method of assigning costs to units, and then testing whether that cost is still recoverable, which may require a write-down. The rules are set by ASC 330 in US GAAP and IAS 2 under IFRS.

Under the cost principle, inventory is first measured at cost, including the purchase price, freight-in, duties and, for manufacturers, direct labor and allocated production overhead under absorption costing. When a business holds identical items bought at different prices, it must use a cost flow assumption to decide which costs go to units sold. The main methods are:

• Specific identification, which tracks the actual cost of each item and suits unique, high-value goods such as cars, jewelry or artwork.
• First in, first out (FIFO), which assumes the oldest goods are sold first, leaving the latest costs in ending inventory.
• Last in, first out (LIFO), which assumes the newest goods are sold first; it is allowed under US GAAP but prohibited under IFRS.
• Weighted average cost, which assigns the same average cost to every unit available for sale.

A wholesaler starts the year with 1,000 units at $10, buys 2,000 at $12 and 1,000 at $14, and sells 3,000 units for $20 each. Goods available for sale total 4,000 units costing $48,000, and 1,000 units remain at year end.

• Under FIFO, ending inventory is the last 1,000 units at $14, or $14,000, and cost of goods sold is $34,000, giving gross profit of $26,000.
• Under LIFO, ending inventory is the first 1,000 units at $10, or $10,000, and cost of goods sold is $38,000, giving gross profit of $22,000.
• Under weighted average, the average cost is $48,000 divided by 4,000, or $12, so ending inventory is $12,000, cost of goods sold is $36,000 and gross profit is $24,000.

The same physical facts produce three different profits. In this period of rising prices, FIFO shows the highest profit and inventory value, LIFO the lowest, and weighted average lies between. A US company would also pay less income tax under LIFO, which is why the method remains popular in some industries despite its drawbacks.

After measuring cost, the business compares it with what the inventory can be sold for. Under IFRS, and under US GAAP for inventory measured using FIFO or average cost (following ASU 2015-11), inventory is carried at the lower of cost and net realizable value, the estimated selling price less costs of completion, disposal and transport. Inventory measured using LIFO or the retail method under US GAAP is still tested using the older lower of cost or market rule, in which market is replacement cost bounded by a ceiling and a floor. Write-downs are usually recorded in cost of goods sold, sometimes through an allowance to reduce inventory to net realizable value. IFRS requires a write-down to be reversed if values recover; US GAAP does not allow reversal.

When an actual count is impractical, such as for interim reports or after a fire, businesses may estimate inventory using the gross profit method or, in retail, the retail inventory method, which converts the retail value of goods on hand to cost using a cost-to-retail ratio. Some industries use special bases: agricultural produce at harvest and commodity broker-traders may measure inventory at fair value less costs to sell. Whatever methods are chosen must be applied consistently and disclosed in the accounting policies, and differences between companies' methods should be considered when comparing measures such as inventory turnover.