Companies need revenues to stay in business. Usually, these revenues come from the sales of products and services. While services are perishable, companies can store products and sell them to various customers. These products form a company’s inventory or stocks. For product-based companies, inventories are crucial in generating sales and satisfying customer demand.
There are several items that go into inventory. These include raw materials, finished goods, work-in-progress, etc. However, the initiating stock is a company’s raw materials. Along with conversion costs, these materials form finished goods. Since production takes place at different times, companies may have different prices on goods and services. Therefore, inventory valuation becomes crucial for companies.
Before understanding inventory valuation, it is critical to define what inventory is.
What is Inventory?
Inventory is a term used to describe a company’s raw materials, finished goods, and work-in-progress. For some, it may also include other items that go into production, for example, work-in-process. Regardless of these items, inventory consists of all physical goods and items that companies. However, these goods must be a company’s products or contribute to the process of manufacturing them.
Inventory is one of the most crucial assets for companies. Usually, companies keep inventory to be ready for new orders and meet customer demand. Every company will have a policy on how long it will hold stock. Several models can also help optimize this process, for example, the economic order quantity. Some companies may not keep stock at all and use a just-in-time system or other relevant techniques.
Regardless of the processes that companies use, they will hold inventory at one point or another. However, it will not include goods not part of the production process or finished products. For example, stores and spares are items that will not be a part of a company’s inventory. For most companies, raw materials and finished goods are the only items under this heading.
A company’s inventory appears on the balance sheet as a current asset. Usually, companies assume they can sell or liquidate these assets within a year. Therefore, the classification under current assets becomes necessary. This inventory also impacts the income statement through movements. However, this impact comes in the form of the cost of goods sold during the year.
What is Inventory Valuation?
Ideally, companies acquire raw materials at the same rate and bear similar costs to produce finished goods. Practically, however, it is not possible to do so in most circumstances. Most companies acquire raw materials at variable prices during different times. Similarly, the conversion costs borne on these products differ over time.
Companies can be profitable as long as the cost for their finished goods is lower than the selling price. However, they must also report these figures in the financial and management records. For that, they must evaluate the inventory based on various techniques. This process is crucial in deriving an accurate cost for the goods that companies sell.
The requirement for inventory valuation also relates to the matching principle in accounting. This principle requires entities to match the revenues they generate to the relevant expenses during an accounting period. Therefore, it is crucial for companies to derive a cost of the inventory they sell to report it with the revenues they help generate.
In ideal circumstances, companies will know the cost for each item sold. In practice, however, it is not viable to do so. Most companies only evaluate their assets at the end of the accounting period. Therefore, the process to report the costs for the items sold may become complicated. However, companies can use one of the many inventory valuation techniques to reach a cost for inventory.
What are Inventory Valuation techniques?
Usually, companies evaluate their stock at the year-end. However, this evaluation requires them to use a value for all the available inventory. As mentioned, keeping track of every item may not be an option as it is costly and tedious. Therefore, companies must use inventory valuation techniques to evaluate their goods in stock. Generally, there are three techniques used to do so.
The FIFO method of inventory valuation considers the first manufactured goods to be the ones sold first. In other words, it assumes a company sells finished goods in the order it produces them. Therefore, any goods produced earlier will also get sold before others. In practice, the same may not apply due to the reasons stated above. However, this method only assumes it does.
The FIFO method of inventory valuation provides a logical base for evaluating inventory. Most companies sell products in the same order as they manufacture them. This method allows companies to determine value based on stock on hand even though the cost of goods sold may fluctuate. When material costs decrease, this method can produce better results.
The LIFO method of inventory valuation considers the last manufactured goods to be the ones sold first. In other words, it assumes a company sells finished goods in the reverse order of which they manufacture them. As mentioned above, doing so may not be possible. However, this valuation method also only assumes it does.
The LIFO method of inventory valuation can produce better results when material costs are increasing. Companies can also get several tax advantages by using this method. However, the IFRS prohibits the use of LIFO to evaluate inventory in financial reporting. Similarly, it does not provide a logical base for inventory valuation.
Weighted Average Cost (WAC)
The WAC method of inventory valuation does not consider when companies manufacture goods. Instead, it takes a weighted average of all items to determine the amount that must go into evaluating inventory. In this method, the cost of goods sold and inventory take value from the average cost of all items purchased during a period.
The WAC method provides a middle ground to the discussions between FIFO and LIFO. Comparatively, it is also easier to calculate as the other methods require complicated calculations. For companies with a high volume of inventory, this may be the best option available. However, the prices usually don’t reflect the actual value of an item.
What is the LIFO Conformity Rule?
As mentioned above, LIFO is not an available option under the IFRS. However, the US GAAP allows companies to use it. Similarly, some companies can get tax advantages by using LIFO rather than using other inventory valuation techniques. In the past, some companies abused this position by using LIFO to report inventory for tax reasons. However, their financial statements included inventory based on another valuation technique.
This process allowed companies to obtain tax advantages while also exaggerating their financial performance. However, the LIFO conformity rule changed that. The LIFO conformity rule states that companies must use the LIFO cost flow method to calculate taxable income if used for the financial statements. However, this conformity rule only applies in the US and for companies that use the US GAAP.
Therefore, if a company uses the LIFO valuation technique for its financial statements, it must also use it for its taxable income. In short, the LIFO conformity rule requires companies to use the same inventory valuation technique for financial and tax purposes. This rule prevents companies from using the LIFO method to reduce the amount of their taxable income, going against their financial statements.
How does the LIFO Conformity Rule work?
When a company reports its inventory in its financial statements, it must choose between inventory valuation techniques. In the past, companies used different methods for tax purposes from their financial statements. This process allowed companies to report better figures in the financial statements. In contrast, it reduced the taxable income on which they had to pay taxes.
However, the LIFO conformity rule prohibited this process. Due to this rule, companies must use LIFO for both their financial statements and taxable income. However, the conformity rule does not require the use of LIFO if a company does not choose to do so. It only states that if a company uses LIFO, it must use the method for tax and financial purposes.
This rule can result in companies losing out on tax benefits or reporting lower figures in the financial statements. However, it also prevents abuse by using dual standards for reporting income under tax and financial reports. Companies can also use one of the other two common methods. However, they must conform to this rule if they choose to use LIFO for tax or financial purposes.
Inventory is one of the most critical assets for companies that sell products. There are several methods that companies can use to evaluate their stock. Similarly, these include FIFO, LIFO and WAC, among others. The LIFO conformity rule requires companies to use LIFO for tax purposes if used for financial reporting or vice versa.