The method used to account for inventory affects the company’s income statement, balance sheet, and related financial ratios. More importantly, since the choice of inventory method impact the taxes paid by the company it affects cash flows. Unlike depreciation methods, inventory accounting methods must be the same for taxes as for financial reporting.
U.S. Generally Accepted Accounting Principles (GAAP) requires inventory valuation on the basis of lower of cost or market (LCM). If replacement t cost is rising, the gains in the value of inventory are ignored, and the inventory is valued at cost. However, losses in the value of inventory due to obsolescence, deterioration, etc., are recognized, and inventory is written down to its new market value. Remember, LCM is applied regardless of the inventory costing method used.
In general, cost represents reasonable and necessary costs to get the asset in place and ready to use,
Merchandise inventories include costs of purchasing, transportation, receiving, inspecting, etc.
Manufactured inventories include costs of direct materials, direct labor, and manufacturing overhead (i.e., all other indirect costs).
A basic inventory formula relates the beginning balance, purchases, and cost of goods sold (COGS) to the ending balance. Memorize and understand the relationships in the following equation:
Ending inventory =beginning inventory + purchases – COGS