Over time, many businesses build up inventories of goods available for sale. Prices change; they generally increase over time due to inflation. Because of this effect, an item that cost the business one amount a year ago, may cost more when purchased today. A decision must be made as to which item gets sold and removed from inventory. This decision affects both the inventory value as well as the cost of goods sold account related to the sale.
A popular method of inventory valuation is LIFO or, “last in, first out.” In other words, the most recent cost (often the most expensive) is the one that is removed from inventory and booked as the cost of goods sold. This method minimizes profits (and therefore income taxes.)
Another method is FIFO or, “first in, first out.” Using this method, the oldest cost is the one that is booked. Some businesses may also use an “average cost” method to value inventory and book costs of goods sold.
When a company uses LIFO, it will list a “LIFO Reserve” on its balance sheet or in the footnotes to the financial statements. The LIFO reserve represents the difference between LIFO and FIFO; it is the amount by which inventory under LIFO would be adjusted to be valued using FIFO.
Another important aspect of inventory valuation and inventory analysis involves whether the business regularly conducts a physical count of its inventory. This activity helps ensure that the stated balance is accurate and identifies “shrinkage” or loss of inventory due to misplacement, theft, and bookkeeping error. Similarly, businesses occasionally write off obsolete inventory that no longer has value or cannot be sold. If the business has not performed an inventory count or written off obsolete items, then the inventory value on the balance sheet is likely to be overstated.