Valuing Inventory

Inventory is often one of the most significant current assets that a company reports on its balance sheet. The inventory dollars shown on a balance sheet represents the value of the asset on- hand (yet to be sold). During the fiscal year, as sales of product are made, the cost of the product sold must be taken out of inventory (the asset) and reclassified as cost of goods sold (an expense). Like all other journal entries, this entry reflects what is actually happening - product has left the company as a result of the sale - so inventory must be reduced. The cost of the inventory is then matched (as an expense) with the revenue (sale) that it generated.

In companies that have a high volume of sales transactions it is unrealistic to attempt to determine the exact cost of the specific item sold. For example, suppose you are Wal-Mart....with the thousands of product shipments that come into and go out of their regional warehouses, how realistic is it going to be to determine the exact cost of the specific pack of athletic socks that was sold at 2:45 today at the store in Des Moines? Pretty unrealistic, right?

In recognition of the impossibility, the Accounting profession allows companies (such as Wal-Mart) to make an assumption about how product is sold, in order to determine the cost of the product - as long as the assumption is based on an approved methodology. There are three approved costing methodologies for determining cost of goods sold and the remaining inventory asset - First in First Out (FIFO), Last In First Out (LIFO) and Weighted Average cost. A company chooses one of these approved methods and must stick with it - no changing methods every year! However, a different method can be used for different divisions within a company or for different categories of inventory.

When using FIFO, LIFO or Average cost - the goal is to determine the dollar amount to be used to create the journal entry to move cost of product sold out of inventory and into cost of goods sold;

DR: Cost of Goods Sold
CR: Inventory

Additionally, the timing of when this journal entry is made will affect the amount of the calculation. If the company is using a perpetual inventory accounting system, the calculation and associated journal entry will be made every time a sale occurs. However, if the company is using a periodic inventory system, the calculation and associated journal entry to affect inventory will be made, once per period at the end of the period.

The combination of the cost assumption (FIFO, LIFO, Average) used in the accounting for inventory combined with the timing (Perpetual, Periodic) gives rise to the statement that there are in fact SIX ways to account for inventory - FIFO Periodic, FIO Perpetual, LIFO Perpetual, LIFO Periodic, Weighted Average Perpetual and Weighted Average Periodic. What is facinating is that depending on the combination chosen (LIFO Periodic vs LIFO Perpetual), a company can have FIVE different calculated amounts that could be used for cost of goods sold. Notice I said FIVE different amounts (but SIX methods, right? So what's up with that?). That's because FIFO Periodic will give the same calculated amount for cost of goods sold as FIFO Perpetual will. However, LIFO Periodic will give a different calculated amount than LIFO Perpetual and so will Weighted Average Periodic vs. Weighted Average Perpetual.

As long as a company is consistently using one of the approved methods it can report the resulting calculated amount as cost of good sold on its income statement and as a reduction to the inventory(asset) balance. Yet, another company, with the exact same data, will report a different amount, simply because a different method was chosen. The choice made will depend on several factors, including the tax benefits of using one method over another. For example, in periods when inventory/product costs are rising, LIFO Periodic will yield the highest cost of goods sold amount and therefore the lower net income - and thus, the lower tax charge. However, using a perpetual inventory system yields operational benefits that may outweigh the tax benefit. Each company has to make its own determination.