Why It Matters: Inventory Valuation Methods

Why learn about accounting and reporting of inventory?

A grocery store aisle.

For a merchandising company, inventory can be one of the largest assets on the books, and one of the most complicated to account for. Unlike fixed assets, like buildings and equipment, that are bought and held for a long time, inventory for most companies is being bought and sold constantly.

You may not always see this continuing turnover, but if you think about a grocery store, you know that the merchandise is in a constant state of flux. Even a department store, like Walmart, is always buying and selling inventory. That is their primary business function. In fact, on January 31, 2020, Walmart reported over $44 billion dollars in merchandise inventory, and for that fiscal year, the company reported almost $400 billion in cost of goods sold (COGS). That means that statistically, the inventory was turning over about nine times per year. In other words, the average item at Walmart sold within 40 days. Of course, lettuce in the grocery department sells within a few days of being purchased (hopefully), and lawnmowers may take a month or two.

For many businesses then, “valuing” inventory is a significant accounting issue. These are the basic accounting principles:

  • Historical cost: using objective evidence to establish the “book value,” rather than subjective measures such as fair market value. So, in essence, we are not establishing the value of inventory, but rather its cost.
  • Matching: recognizing the COGS against the revenue generated.
  • Conservatism: recognizing a loss in the value of the inventory when it happens, but not increases in value (we recognize the fair market value of the inventory when we sell it, and the difference between the sales price and the cost is our gross profit).
  • Materiality: how do we best account for the costs of inventory without getting lost in the details?
  • Disclosure: in addition to the number on the balance sheet, what do the users of the financial information need to know to make an informed investment or lending decision?

We’ll study each of these principles in this module, and although they are all interconnected, we’ll try to tackle each one independently.