Putting It Together: Inventory Valuation Methods

In this module, you experienced a wide variety of issues related to “costing” inventory, and how the combinations of different methods can lead to significantly different results. If you were a mathematician, you’d want different experimenters to be able to replicate your scientific explorations with similar if not exact outcomes, but in accounting, because we can make choices, three different accountants could come up with three different versions of financial results for the same company.

That’s why we disclose, in notes to the financial statements, our significant accounting policies (except for the use of perpetual or periodic systems of accounting for COGS).

A man on a computer.

For instance, Boeing Company showed almost $77 billion in inventory on its 2019 balance sheet, which ranged from parts to work-in-process to used aircraft purchased for resale. The footnote describing how inventory was accounted for and valued was several pages long, going into detail about the use of estimates and how costs were assigned to various product lines (Boeing Annual Report, accessed July 9, 2020). Since no specific cost flow assumption was identified, we can probably assume that the company is using specific identification for those large items.

See if you recognize the concepts in the excerpt from that long Boeing footnote (page 66):

Used aircraft acquired by the Commercial Airplanes segment are included in Inventories at the lower of cost or net realizable value as it is our intent to sell these assets.

In contrast, Caterpillar, Inc., reporting $11 billion in machinery in inventory, had a much simpler footnote that we can easily reproduce right here (Caterpillar Annual Report, accessed July 9, 2020):

C. Inventories

Inventories are stated at the lower of cost or net realizable value. Cost is principally determined using the last-in, first-out (LIFO) method. The value of inventories on the LIFO basis represented about 60 percent and 65 percent of total inventories at December 31, 2019 and 2018, respectively.

If the FIFO (first-in, first-out) method had been in use, inventories would have been $2,086 million and $2,009 million higher than reported at December 31, 2019 and 2018, respectively.

Even though the company uses LIFO, and could have used LCM, it chose to use LCNRV. Also, you might think that, like Boeing, the company would use a specific identification method of assigning costs, but it is using LIFO. That means that costs assigned to inventory items are old, old costs, which reduces inventory on the balance sheet, which then increases COGS, which in turn decreases gross profit and the bottom line.

During inflationary times, companies can reduce their taxable income by using the LIFO cost flow assumption for inventories. However, the tax savings from using LIFO come at a cost. Under the LIFO conformity rule in IRC Sec. 472(c), if a taxpayer opts to use LIFO for tax purposes, it must also use it for general financial reporting. This choice can be a problem for companies that are moving toward more global operations because although GAAP allows LIFO, IFRS does not.

One final note: Similar to GAAP, IFRS also require inventory to be reported at the LCM, and under IFRS, the market value of inventory is defined as the NRV. If the historical cost is higher than the sales price, then inventory must be written down. This is really the same as the GAAP LCNRV rule.

As you can see, inventory accounting can be complicated, and many big businesses have entire departments dedicated to accounting for inventory. Because of this complexity, some accountants have built an entire career around purchasing, inventory, and related issues.