Generally, the balance sheet of a U.S. company must value inventory at cost. In other words, a company's inventory is not reported at the sales value. (An exception occurs when a company's inventory consists of readily salable commodities that have quoted market prices.)
Since the costs of products may change during an accounting year, a company must select a cost flow assumption that it will use consistently. For instance, should the oldest cost be removed from inventory when an item is sold? If so, the company will select the cost flow assumption known as first-in, first out (FIFO). In the U.S. an alternative is to remove the period's most recent cost when an item is sold. This is known as last-in, first-out (LIFO). Another option is to use an average method such as the weighted-average method or the moving-average method. Both the LIFO method and the average methods will result in different values depending on whether a company uses the perpetual method or the periodic method. Still another option is to use the specific identification method.
The LIFO cost flow assumption can be achieved by tracking the units in inventory or by using price indexes. When price indexes are used, it is referred to as dollar-value LIFO. (Retailers often use a technique called dollar-value retail LIFO.)
The accountants' concept of conservatism can result in some inventories being valued at less than cost. Hence, an additional method for valuing inventory is the lower of cost or net realizable value. For example, if the net realizable value of a company's inventory has declined to an amount that is less than cost, the company will likely have to reduce its inventory cost. The amount of that adjustment will also reduce the current period's net income.
A company's inventory must be measured and reviewed very carefully as it is an important amount for determining a company's financial position and profitability.
