Inventory Valuation Basics

Income measurement and asset valuation are two concepts at the core of accounting. Recall that the matching principle requires that costs incurred to generate revenue should be recognized in the same period that the revenue is earned. For most merchandising companies, the cost and control of inventory is the focal point of the operation. Inventory valuation applies to many companies. Thinking about this lesson, choose which companies below might benefit from inventory valuation.

Company Type  
1. a law firm   _________________
2. an electronics company   _________________
3. a car dealership   _________________
4. a textbook company   _________________

Inventory Systems and Costing Methods

Inventory systems and inventory costing methods must be understood for proper inventory valuation and measurement. The two basic systems of accounting for merchandise inventory are the perpetual inventory system and the periodic inventory system. Under the perpetual inventory system, continuous records are kept of the quantity and, usually, the cost of individual items as they are bought and sold. Under the periodic inventory system, the inventory not yet sold, or on hand, is counted periodically. This physical count is usually taken at the end of the accounting period.

What type of inventory tracking system is in use when changes in inventory are immediately displayed on the balance sheet?

“Goods Flow” versus “Cost Flow”

The term “goods flow” refers to the PHYSICAL MOVEMENT of inventory through the operations of the business. In most business, we try to sell our oldest merchandise first. The term “cost flow” refers to the COST associated with the assumed flow of merchandise (i.e. how much of the cost is allocated to to the items sold and how much is allocated to the unsold ending inventory). An accounting issue arises when identical units of merchandise are acquired at different unit costs during a period. In such cases, when an item is sold, it is necessary to determine its cost using a cost flow assumption and related inventory costing method. Does the “cost flow” method need to be the same as as the physical “goods flow”?   _________________Different valuation methods produce significantly different values for cost of merchandise sold and subsequent inventory levels. This means that the choice of inventory valuation method can have a significant effect on a company’s financial position.

Although the implications are far reaching, the two items most directly and immediately affected by the choice of inventory valuation method are cost of merchandise sold on the   _________________   and inventory on the   _________________   .

The following formula illustrates the relationship between the cost of merchandise sold and the ending inventory. The part of the cost of merchandise available for sale is allocated to the cost of merchandise sold for the inventory that is sold and the value of the unsold inventory is assigned to the ending inventory. Therefore, a change in the amount of the cost of merchandise will impact the value of the ending inventory.

Beginning inventory
+ Purchases
= Cost of merchandise available for sale
Cost of merchandise sold
= Ending Inventory

How would an inventory valuation method that results in higher cost of merchandise sold for the current period affect the following items?