Question

There seems to be a number of ways to cost inventory, LIFO, FIFO, Wt. Avg., etc. Since comparability is important, why don’t the rules limit you to one method? Also even though you can use any of these, there is also a Lower of Cost or Net Realizable Value rule that has to be followed as well. Can you explain why the two rules and are you allowed to choose?

Answer 1

Valuation of inventory is a two-stage process.

First, we determine the cost of closing inventory. Here we have many options such as FIFO, LIFO and weighted average. The business should select the method which is most relevant to their operations. For eg, if a company has the policy of clearing old inventory first, then it should follow the FIFO method. If the company prefers clearing latest inventory, it should adopt the LIFO method. Similarly, if a company has no preference of order of clearance of stock, then it should adopt the weighted average method of determining the cost of the inventory. Hence, due to the varying business models, rules don't limit us to one method as a method which may be appropriate for one business, might be inappropriate for another one. Not limiting to one rule helps more accurate cost determination of closing inventory for various businesses.

The second part of valuation involves comparing the cost with the net realizable value. The inventory is then valued at the lower of cost and net realizable value. This is to accommodate the concept of prudence applicable to current assets. Normally assets are recorded at their cost. However, since current assets are more liquid, we do not value them higher than their net realizable value as this may reflect an inaccurate image in the balance sheet. The loss on such fall in value should be recognized immediately as per the principle of prudence.