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One important element of the financial statements is the volume of goods, whether it is goods finished or raw materials, i.e. the inventory. It helps to determine the cost of goods sold and allows matching of that with the revenues that it generates to give us a reliable realized income value. For a company such as Lotza Inventory Inc, it is likely that they hold large volumes of inventory that was purchased at different prices. To specifically identify the cost of individual items sold in order to obtain the precise cost of inventory would not only be expensive, but almost impossible. Typically, in these situations one of several cost flow assumptions is made, e.g. last-in-first-out (LIFO), first-in-first-out (FIFO) or weighted average. It is not necessary to select an assumption that is consistent with the physical movement of goods, however, it is necessary to choose the assumption which most clearly reflects the periodic income of the company. Several points must be carefully considered when deciding on which assumption to adopt, one of which is the effect on net income. Net income is the lowest with the LIFO assumption, followed by weighted average then FIFO. This has great implications on the tax benefits or burdens the company will experience, e.g. substantial tax burden will be the result of a switch from LIFO to FIFO. Another point to consider is the matching concept; using LIFO, a better measure of current earnings is provided as the more recent costs are matched against current revenues. The method chosen must be disclosed on the balance sheet of the financial statements besides inventory.
Other ways of putting value to inventory includes'Lower of Cost or Market', this valuation technique conflicts with the historical cost principle as it replaces it with a market value found by taking the replacement cost of inventory. This principle is only used when the future utility of the inventory is no longer as great as its original cost, i.e. when a loss is expected. Although this breaks the historical cost principle it is a conservative approach to inventory valuation and it can be justified by the fact that, using this method, the loss from inventory that occurred is charged against revenue in the period the loss occurred rather than in the period sold when this method is used.
Net realizable value is another valuation method that is calculated by subtracting the cost to sell inventory from the selling price of the inventory This figure gives the amount that will be collected from the inventory in the future and is a very conservative measure of the cost of your inventory. In certain circumstances this method of valuation is used even if this amount exceeds the historical cost of the goods.
For large retailers with a large amount and variety of inventories, it would be impractical to use the specific valuation method to value inventory, in which case the Retail Inventory Method will be most suitable as it will give a fairly reliable estimate of the ending inventory value with no physical count of the inventory required. It does this by using calculating a ratio between cost and retail price then this ratio is applied to the ending retail inventory to compute the cost of the ending inventory. However, this method of valuation causes an averaging effect amongst varying rates of gross profits for inventory and no allowance is made for possible distortion of these results.
One common agreement that does not have an obvious accounting treatment is when purchase commitments are made for example, an agreement to buy inventory months in advance of delivery or payment. The problem is deciding whether to record this purchase commitment as a liability or as an asset, if at all. The lastest accounting treatment for this type of transaction is to make no recognition of this at the date of inception as the contract is'executory' i.e. both parties has yet to make any considerations to the contract, this is significantly different to the treatment of other inventory. Neither party should be required to make entries regarding this commitment in their financial statements until the title of the merchandise is passed on to the buyer. However, under the Generally Accepted Accounting Principles it is required to disclose of this in the notes of the financial statements, in order to avoid the statement becoming misleading. This is not to say that losses that occur on the purchase commitment should not be recognised in the financial statements. If the price, that both parties agreed on, is expected to exceed the market price then the loss should be reported in the income statement under'Other expenses and losses' and also reported as an'estimated liability on purchase commitments' in the current liabilities section of the balance sheet because the contract has not yet been performed and is at present a liability. Similar treatment is used for the accounting of other contracts that are executory in nature, for example, leases which are merely contracts agreeing to have the right to property in return for future rental payments. This should not be included in the financial statements as assets and liabilities but should be disclosed in the notes. The reason for these large variety of valuation techniques permitted is so that any business is able to use at least one of them to value their inventory with convenience and as there are so many different types of organisations with differing inventory characteristics, there has to be a number of methods to suit each organisation valuation needs. Although there is some flexibility when choosing which method to use when valuating inventory, generally a uniform method of inventory pricing is adopted by all companies within a given industry to allow comparisons between different companies in the same industry to be made.
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