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.
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