Inventory
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In accounting Inventory refers to the tangible property which is held for sale in the ordinary course of business. For a manufacturing concern it also includes merchandise stock that is in process of production for such sale, or is to be currently consumed in the production. In other words inventory includes finished products, work in process and raw materials held for resale. Depending on the business it can be anything ranging from wood, minerals, oil to toys, furniture, food items etc. Inventory is classified as current asset on the balance sheet.
The value at which inventory is recorded has a dual significance. First the amount shown in the balance sheet as a current asset is likely to be an important component of working capital. Second and more importantly cost of inventory directly affects the amount of net income for the period. Remember Cost of goods sold is computed by adding beginning inventory and purchases during the year and subtracting the ending inventory from the total.
Cost of goods Sold = Beginning Inventory + Purchases - Ending Inventory
Therefore Valuation of inventory directly impacts the net income. Lesser the cost of goods sold higher will be the income or in other words higher the cost of ending inventory, higher the net profit for the period. To avoid manipulation by business GAAP has laid down specific guidelines for inventory valuation.
Inventory Valuation
Cost of inventory includes all expenses incurred to bring an item to its existing condition and location. It, thus includes cost of raw materials, processing expenses, shipping and handling charges, freight etc. The basis of inventory valuation must be consistently applied and should be disclosed in the financial statements.
There are three basis approaches to valuing inventory that are allowed by GAAP -
First-in,
First-out (FIFO)
Under FIFO, the cost of goods sold
is based upon the cost of material bought earliest in the period, while the cost
of inventory is based upon the cost of material bought later in the year. This
results in inventory being valued close to current replacement cost. During
periods of inflation, the use of FIFO will result in the lowest estimate of cost
of goods sold among the three approaches, and the highest net income.
Last-in,
First-out (LIFO)
Under LIFO, the cost of goods sold
is based upon the cost of material bought towards the end of the period,
resulting in costs that closely approximate current costs. The inventory,
however, is valued on the basis of the cost of materials bought earlier in the
year. During periods of inflation, the use of LIFO will result in the highest
estimate of cost of goods sold among the three approaches, and the lowest net
income.
Weighted
Average
Under the weighted average approach, both
inventory and the cost of goods sold are based upon the average cost of all
units bought during the period. When inventory turns over rapidly this approach
will more closely resemble FIFO than LIFO.
Lower of cost
or market value
A departure from the cost basis is
required when the utility of goods is less than cost. Market means current
replacement cost except that it should not exceed the net realizable value
(i.e., estimated selling price - cost of completion and disposal) nor should it
be less than net realizable value reduced by an allowance for normal profit
margin. In such cases lower of cost or market value is used.
Firms often adopt the LIFO approach for the tax benefits during periods of high inflation, and studies indicate that firms with the following characteristics are more likely to adopt LIFO - rising prices for raw materials and labor, more variable inventory growth, an absence of other tax loss carry forwards, and large size. When firms switch from FIFO to LIFO in valuing inventory, there is likely to be a drop in net income and a concurrent increase in cash flows (because of the tax savings). The reverse will apply when firms switch from LIFO to FIFO.
Given the income and cash flow effects of inventory valuation methods, it is often difficult to compare firms that use different methods. There is, however, one way of adjusting for these differences. Firms that choose to use the LIFO approach to value inventories have to specify in a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is termed the LIFO reserve. This can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based upon FIFO valuation.
Inventory Recording Systems:
Perpetual or Periodic
Companies may use either the perpetual system or the periodic system to account for inventory. Under the periodic system, merchandise purchases are recorded in the purchases account, and the inventory account balance is updated only at the end of each accounting period. Perpetual inventory systems have traditionally been associated with companies that sell small numbers of high-priced items, but the development of modern scanning and computer technology has enabled almost any type of merchandiser to consider using this system
Under the perpetual system, purchases, purchase returns and allowances, purchase discounts, sales, and sales returns are immediately recognized in the inventory account, so the inventory account balance should always remain accurate, assuming there is no theft, spoilage, or other losses. Under the periodic system, the inventory and cost of goods sold accounts are updated only periodically, but under the perpetual system, entries that recognize a transaction's effect on these accounts occur when the revenue from the sale is recognized.