How Is Inventory Valued?

Inventory represents a significant asset for many businesses, encompassing items held for sale, goods in the process of production, and raw materials used in manufacturing. Valuing inventory is a fundamental accounting practice. This valuation is essential for accurately presenting a company’s financial health and making informed operational decisions.

Understanding Inventory Fundamentals

Inventory valuation is important as it directly influences a company’s financial statements. On the balance sheet, inventory is classified as a current asset, reflecting its expectation to be converted into cash within a year. The reported value of inventory directly impacts total assets, providing stakeholders insight into financial position.

Inventory valuation also directly affects the income statement through Cost of Goods Sold (COGS). When inventory is sold, its cost transfers from the balance sheet to COGS, reducing gross profit and net income. Incorrect valuation can lead to misstated COGS, impacting profits and tax liability. Accurate valuation also provides management with data for pricing, purchasing, and production planning.

Key Inventory Cost Flow Methods

Businesses use various cost flow methods to value their inventory and goods sold. These methods assume which inventory items are sold first, rather than tracking physical flow. Each method impacts reported cost of goods sold and remaining inventory value differently.

The First-In, First-Out (FIFO) method assumes the first units purchased or produced are the first ones sold. This aligns with the physical flow for many businesses, particularly those dealing with perishable items or products with expiration dates. Under FIFO, ending inventory consists of the most recently acquired items, while cost of goods sold reflects the oldest items.

The Last-In, First-Out (LIFO) method assumes the last units purchased or produced are the first ones sold. Consequently, cost of goods sold under LIFO includes the most recent inventory acquisitions. This method values ending inventory at the cost of the oldest items. While LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP), it is not allowed under International Financial Reporting Standards (IFRS).

The Weighted-Average method calculates an average cost for all goods available for sale. This average cost applies to both units sold and units remaining in inventory. This method smooths price fluctuations, providing a middle-ground valuation compared to FIFO or LIFO. It is often favored by businesses with a large volume of undifferentiated items.

The Specific Identification method assigns costs to individual inventory items based on actual acquisition cost. This method is practical for businesses selling unique, high-value items that can be individually tracked, such as custom furniture, art, or high-end automobiles. It directly matches an item’s cost to its revenue when sold. However, it is impractical for companies with a large volume of identical, low-cost items due to extensive record-keeping.

Inventory Accounting Systems

Inventory cost flow methods are applied within two primary accounting systems: perpetual or periodic. These systems dictate how and when inventory balances and Cost of Goods Sold are updated. System selection impacts real-time inventory visibility.

A perpetual inventory system continuously tracks inventory balances and Cost of Goods Sold with each transaction. It updates records in real-time as items are purchased, sold, or returned. Businesses using a perpetual system can determine inventory levels and COGS at any moment. This tracking is often supported by integrated point-of-sale (POS) systems and inventory management software.

In contrast, a periodic inventory system updates inventory balances and calculates Cost of Goods Sold only at the end of an accounting period. This involves a physical count of all remaining inventory. Purchases are recorded separately, and COGS is determined by a formula involving beginning inventory, purchases, and ending inventory from the physical count. This system is simpler to maintain and suitable for smaller businesses with low transaction volumes or less complex inventory.

The application of cost flow methods varies between these systems. In a perpetual system, FIFO or LIFO applies to each sale, immediately impacting COGS and remaining inventory. For the weighted-average method in a perpetual system, a new average cost is calculated after each purchase (a moving-average). With a periodic system, FIFO, LIFO, or weighted-average methods apply to total goods available for sale at the end of the accounting period, after a physical count determines ending inventory.

Adjustments to Inventory Value

Beyond initial costing, inventory values may require adjustments to prevent overstatement on financial statements. Under U.S. GAAP, the “Lower of Cost and Net Realizable Value” (LCNRV) principle generally applies to most inventory. This principle ensures inventory is reported at the lower of its historical cost or net realizable value.

Net realizable value (NRV) is the estimated selling price of inventory in the ordinary course of business, less predictable costs of completion, disposal, and transportation. For example, if a product costs $100 but sells for an estimated $90 after selling expenses, its NRV is $90. This adjustment prevents assets from being carried at a value higher than what they are expected to generate in cash.

If inventory’s net realizable value falls below its historical cost, a write-down is required. This means the inventory’s balance sheet value is reduced to its NRV, and a loss is recognized on the income statement in the period of decline. This adjustment reflects the conservative accounting principle that potential losses should be recognized when identified, preventing overstating assets and profits and providing a more accurate financial picture.

Under U.S. GAAP, once inventory is written down, the write-down generally cannot be reversed even if value later recovers. For inventory valued using LIFO or the retail inventory method, U.S. GAAP uses a “lower of cost or market” rule, where “market” has specific definitions.