A merchandising business purchases inventory that will be sold to consumers in the normal course of operations. As with any other business-related activity, the goal is to generate a profit. Therefore, accurately tracking the cost of the inventory purchased is primarily essential for computing profits. Inventory valuation methods accomplish the goal of valuing the inventory as accurately and efficiently as possible, while also allowing the company to create a system to track inventory costs and the flow of inventory. As a result of this system, a business can calculate profit and loss and accurately report inventory on its financial statements.
At A Glance
Inventory control in a business is important for safeguarding the inventory from theft and damage, and to ensure that inventory is accurately reported on financial statements.
- Four common accounting principles associated with inventory are consistency, disclosure, materiality, and conservatism.
- The inventory equation is used to calculate the cost of goods sold (COGS). It also helps show the flow of inventory throughout the period.
- A uniform system of valuing inventory costs is essential to maintain fairness and measurability in periods of cost increases and inflation. Four inventory cost flow assumptions or methods are used for valuation: specific identification; first in, first out (FIFO); last in, first out (LIFO); and weighted average.
- Under the perpetual inventory system, inventory is constantly valued, maintained, and recalculated with each new purchase of inventory.
- Under the periodic inventory system, inventory records are updated when a physical count of goods on hand is done, whereas under the perpetual inventory system, inventory records are constantly updated.
- In a period of rising prices, the first in, first out (FIFO) method allows an organization to record lower inventory costs (cost of goods sold) on the income statement and higher amounts of inventory on the balance sheet.
- In a period of rising prices, the last in, first out (LIFO) method allows an organization to record higher inventory costs (cost of goods sold) on the income statement and lower amounts of inventory on the balance sheet.
- The weighted average method allows the organization to record average inventory costs (cost of goods sold) on the income statement and averaged amounts of inventory on the balance sheet.
- Depending on which method of inventory valuation is used, the company will report different amounts of net income and total assets.
- Increasing or decreasing prices will have different effects on inventory valuation methods, such as FIFO and LIFO.
- The lower-of-cost-or-market inventory valuation method helps to determine which value is lower—the inventory's original cost or its market price. The lower value is reported.
Errors may occur in the inventory valuation process because of incorrect physical counts of inventory on hand, incorrectly applied costs, miscounting inventory in transit, or miscounting inventory on consignment.