Valuation of inventory
If an inventory item is worth less than what you paid for it, you must adjust the cost down to the current market value.
Accountants refer to this rule as the lower of cost or market, and the policy is consistent with the principle of conservatism. If the dollar value of inventory has declined in value, the amount must be adjusted in the financial statements.
If you apply the lower cost or market policy, the financial statements will be more accurate.
Sunshine sells every inventory item within six months, and Julie does not purchase items that decline in value over that period of time. The bigger issue for Sunshine is determining which specific items were sold, and the original cost.
First in, first out method
The first in, first out (FIFO) method assumes that the oldest items in inventory are sold first.
The current inventory of Seaside Candles includes these purchases:
- 50 candles purchased on 1 Dec for $10 each
- 25 candles purchased on 15 Dec for $12 each
- 75 candles purchased on 20 Dec for $13.50 each
If Sunshine sells a total of 40 candles on 25 December, the FIFO method values the candles sold at $10 each.
Most companies use the FIFO method to value items sold out of inventory. Some firms, however, use last in, first out (LIFO) method.
Last in, first out method
To understand the LIFO method, think about buying milk at the grocery store.
The oldest litres of milk are pushed to the front of the refrigerator, so that you’re more likely to buy the older product before it expires. To get to the newer milk, you have to reach behind the old stuff.
Getting to the newer milk is the LIFO method.
LIFO assumes that the newest units are sold first. If Sunshine uses the LIFO method, the 40 candles sold on 25 December are valued at $13.50 each.
Accounting principles require that you consistently use the same method, so that your financial results are consistent from year to year. Fortunately, accounting software can track the costs and post the correct amounts automatically.
The best way to confirm that the accounting records are correct is to perform a physical count of year-end inventory.