Custom «Inventory Valuation Methods» Essay Paper Sample
Inventory valuation methods are determined by the accounting period. The last in first out (LIFO) inventory valuation method allows companies to postpone pricing gains that effect from higher material costs during inflationary times, by recording cost of sales at the latest inventory acquirement prices. Tuller (2008) says that ending inventory is then devalued by the same amount that earnings are understated. On the other hand the first in first out (FIFO) records cost of sales at the earliest acquisition costs and inventory at the most current prices (Tuller, 2008). The IRS accepts LIFO as well as FIFO as accepted inventory valuation techniques for tax purposes.
According to Raiborn & Cecily (2009), FIFO capitulates a higher net income because the more costly goods (goods purchased later in the period) are alleged to be in ending inventory with the low-cost goods (beginning inventory or early purchases) disbursed to cost of goods sold. Under LIFO, the goods assumed to be in ending inventory are reasonably low cost goods obtained early in the period, whereas the costs of higher priced goods procured later in the period are allocated to cost of goods retailed (Raiborn & Cecily, 2009).In context of the balance sheet, FIFO and LIFO assigns respectively the newest and the oldest per unit costs of goods to ending inventory.
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In addition, Raiborn & Cecily (2009) described that FIFO presents a more suitable balance sheet valuation for ending inventory. For income statement purposes, FIFO and LIFO allocate correspondingly the oldest and newest per unit costs of goods to cost of goods sold. As a result LIFO is usually recognized to better match the current dollars of business revenues and expenses and, in that way, generates a revenue figure that better mirrors a business economic authenticity. Raiborn & Cecily (2009) noted that many investors and business men believe that LIFO does a better job of matching revenue and expenses than does FIFO. Therefore when income determination is thought about a more important issue than balance sheet evaluation, LIFO is favored over FIFO. This is on the basis that many decision makers consider income determination a more decisive issue than balance sheet valuation hence they often wish that businesses use the LIFO method (Raiborn & Cecily, 2009).
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The basic issue in unraveling goods available for sale into two constituents; goods sold and goods not sold is to assign a value to the goods not sold in the ending inventory (Needles & Powers, 2010). The portion of goods available for sale not assigned to the ending inventory is used to verify the cost of goods sold. Since the figures for ending inventory and cost of goods sold are closely related, a misstatement in the inventory amount at the end of an accounting period will cause an equal misstatement in gross margin and income before income taxes in the income statement (Needles & Powers, 2010). The amount of assets and stockholders equity on the balance sheet will be misstated by the same amount.
Consequently, Porter & Norton (2010) described that the purpose of each of the inventory costing methods is to match costs with revenues (256). This implies that if a firm considers that a dissimilar method will result in a better matching than that being presented by the method presently being used, the company should change methods. Needles & Powers (2010) also noted that “FIFO yields the highest inventory valuation, the lowest cost of goods sold and hence a higher net income while LIFO on the other hand yields the lowest inventory valuation, the highest cost of goods sold and thus a lower net income” (pg. 302).
In conclusion, when carrying out inventory valuation, inventory errors should be avoided. Inventory errors arise when the ending inventory is overstated. This leads to the cost of goods sold being understated and on the other hand the net income for the period being overstated. Porter & Norton (2010) indicated that the importance of inventory valuation to the measurement of income can be demonstrated by considering inventory errors. It should be noted that at the end of each book-keeping period, the original cost of inventory as determined using one of the costing methods such as FIFO or LIFO is contrasted with the market price of the inventory. If the market value of the inventory is less than price the inventory is written down to the lower cost.