Why is a product that sells for $50 reported in inventory at its cost of $40?
Generally, items in inventory are valued at their cost—not their selling prices—because of the cost principle.
Another reason for not valuing items in inventory at their selling prices is that inventory items cannot be sold without a sales effort. Until that effort is made and an item is actually sold, the company cannot report the $10 increase from $40 to $50. This is referred to as the revenue recognition principle. In other words, only after an item is actually sold can the company report the revenue of $50 minus the cost of $40 for a gross profit of $10.
There are some exceptions to reporting inventory at cost. One exception is industries where no sales effort is required and the extensive effort of production has been completed. In these industries the inventory may be reported at its net realizable value, which is the sales value minus the costs to dispose of the items. The gold mining industry and certain other commodities are examples.
Another exception to reporting inventory at cost occurs in any industry when a product will have to be sold for less than its cost. In that situation the item should normally be reported at its net realizable value. (U.S. income tax rules require conformity between tax and financial reporting. As a result, there are complexities involved.)
