Valuation of Inventories

According to FASB ASC 330-10, the primary basis of accounting for inventories is cost. Cost is defined as the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.

This definition allows for a wide interpretation of the costs to be included in inventory. For raw materials and merchandise inventory which are purchased outright, the identification of cost is relatively straightforward. The cost of these purchased inventories will include all expenditures incurred in bringing the goods to the point of sale and putting them in a salable condition. These costs include the purchase price, transportation costs, insurance, and handling costs.

It is important to note that purchases can be recorded at their gross amount or net of any allowable discount. If recorded at gross, the discounts taken represent a reduction in the purchase cost for purposes of determining cost of goods sold. On the other hand, if they are recorded at net, any lost discounts are treated as a financial expense, not part of cost of goods sold. The net method is considered to be theoretically preferable, but the gross method is simpler and, thus, more commonly used. Either method is acceptable under GAAP, provided that it is consistently applied.

Full Absorption Costing

As we mentioned above, the basis for valuing any inventory is cost; the basis for establishing cost in a manufacturing operation is to include both acquisition and production costs. This concept is commonly referred to as “absorption” or “full costing.” As a result, the work-in-process (WIP) and finished goods inventory accounts are to include an appropriate portion of direct materials, direct labor, and indirect production costs, which includes both fixed and variable costs. The difficulty in determining the cost for these manufacturing inventory accounts is in the allocation of indirect costs. For not-for-profit organizations with manufacturing or merchandising operations, full absorption costing is the inventory method that should generally be used.

GAAP provides that, under some circumstances, expenses related to an idle facility, excessive spoilage, double freight, and rehandling costs may be abnormal and, therefore, require treatment as period costs. On the other hand, there may be instances in which certain general and administrative expenses are directly related to the production process and, therefore, should be allocated to the WIP and finished goods inventory. In addition, selling costs do not constitute inventory costs. The chart below shows items that would ordinarily be included in inventory to the extent such costs are incident to, and necessary for, production.

FASB ASC 330-10-30, 35 provides that items such as abnormal freight, handling costs, and amounts of wasted materials (spoilage) require treatment as current period charges (i.e., expensed) rather than as a portion of inventory costs. Also, under most circumstances, general and administrative expenses should be included as period charges (i.e., expensed), except for the portion of such expenses that may be clearly related to production and thus constitute a part of inventory costs. Selling expenses continue not to be permitted to be included as part of inventory costs.

The exclusion of all overheads from inventory costs does not constitute an accepted accounting procedure. The exercise of judgment in an individual situation involves a consideration of the adequacy of the procedures of the cost accounting system in use, the soundness of the principles thereof, and their consistent application.

Unallocated overheads are recognized as an expense in the period in which they are incurred. The allocation of fixed production overhead inventory costs is based on the normal capacity of the production facilities. Judgment is required to determine when a production level is “abnormally low,” which means that it is outside the range of expected variation in production. Factors that might be anticipated to cause an abnormally low production level include significantly reduced demand, labor and material shortages, and unplanned facility or equipment downtime. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of abnormally low production or idle plant.

Indirect production costs typically included in inventory under full absorption include:

Direct Costing

The alternative to absorption costing is direct costing. Direct costing is also referred to as variable costing and requires classifying only direct materials, direct labor, and variable overhead related to production as inventory costs. All fixed costs are accounted for as period costs. As mentioned previously, the exclusion of all overhead from inventory costs does not constitute an accepted accounting procedure. This has typically been interpreted to mean that direct costing is not allowable for preparing financial statements in accordance with GAAP.

Specific Identification

The theoretical basis for valuing inventories and cost of goods sold requires assigning the production and/or acquisition costs to the specific goods to which they relate. This method of inventory valuation is usually referred to as specific identification. Specific identification is generally not practical, as the product will generally lose its separate identity as it passes through the production and sales process. Exceptions to this would arise in situations involving small inventory quantities with high unit value and low turnover rate. Because of the limited applicability of specific identification, it is necessary to make certain assumptions regarding the cost flows associated with inventory. These cost flows may or may not reflect the physical flow of inventory in the organization.

Cost Flow Assumptions

According to FASB ASC 330-10-30:

Cost for inventory purposes shall be determined under any one of several assumptions as to the flow of cost factors; the major objective in selecting a method should be to choose the one which, under the circumstances, most clearly reflects periodic income.

The most common cost flow assumptions used are (1) first-in, first-out (FIFO), (2) last-in, first-out (LIFO), and (3) weighted-average. Additionally, there are variations to each of these assumptions which are commonly used in practice.

First-In, First-Out (FIFO)

The FIFO method of inventory valuation assumes that the first goods purchased are the first goods used or sold, regardless of the actual physical flow. This method is thought to most closely parallel the physical flow of the units in most industries. The strength of this cost flow assumption lies in the inventory amount reported on the balance sheet. Because the earliest goods purchased are the first ones removed from the inventory account, the remaining balance is composed of items at the latest cost. This yields results similar to those obtained under current cost accounting on the statement of financial position. However, the FIFO method does not necessarily reflect the most accurate profit picture, as historical costs are being matched against current revenues.

The following example illustrates the basic principles involved in the application of FIFO. Assume that to 100 units in beginning inventory, 200 units are purchased and 175 units are sold during the year.

Given these data, the cost of goods sold and ending inventory balance are determined as follows:

Notice that the total of the units in cost of goods sold and ending inventory, as well as the sum of their total costs, is equal to the goods available for sale and their respective total costs.

The unique characteristic of the FIFO method is that it provides the same results whether inventory is accounted for using either the periodic inventory system or the perpetual inventory system.

Last-In, First-Out (LIFO)

The LIFO method of inventory valuation assumes that the last goods purchased are the first goods used or sold. This allows the matching of current costs with current revenue and, as proponents of the method argue, provides the best measure of periodic income, which is the major objective stated in ARB 43. However, unless costs remain relatively unchanged, the LIFO method will usually misstate the ending inventory balance for balance sheet purposes because inventory usually consists of costs from earlier periods. Critics of the method also point out that LIFO does not usually follow the physical flow of merchandise or materials. However, this last argument should not affect the selection of a cost flow assumption, because the matching of physical flow is not considered to be an objective of accounting for inventories.

The LIFO method usually results in lower earnings and therefore lower income taxes than the FIFO method during periods of rising prices. Unless sales of the inventory are subject to unrelated business income tax, it would be hard to understand why a not-for-profit organization would elect to use the LIFO method; it is not normally cost beneficial for a not-for-profit organization to use the LIFO method. Nevertheless, it is an option for not-for-profit organizations to consider.

Donated Inventories

In some cases, a not-for-profit organization may receive donations of inventory items. Donated materials are recorded as contributions and inventory at fair value in the period received, unless the not-for-profit is passing the inventory through in an agent capacity. GAAP also requires unconditional promises to give materials to be recorded as contributions, even though the not-for-profit organization may not receive the assets until a future period. However, if donated assets have uncertain values, they should not be recorded as assets in the financial statements.

NOTE: The valuation of donated inventories has received scrutiny recently, particularly in the area of donated pharmaceuticals. The FASB is expected to address this area sometime in the future. Donated pharmaceuticals are usually distributed in developing countries. The fair value of these items in the country where they are distributed is usually far below what pricing would be in the United States, which is generally what the fair value is based upon. This has led to accusations that not-for-profit organizations that receive and distribute significant amounts of these types of items are overstating their revenues and expenses.

Interim Financial Statements

The principles used to determine ending inventory and cost of goods sold in annual reports are used in interim reports, although prior GAAP provided the following modifications to inventory accounting principles that may be appropriate in interim periods:

1. The gross profit method may be used to estimate cost of goods sold and ending inventory.
2. When LIFO layers are liquidated during the interim period but are expected to be replaced by year-end, cost of goods sold should reflect current costs rather than old LIFO costs.
3. Temporary market declines need not be recognized if substantial evidence exists that market prices will recover.
4. Planned standard cost variances expected to be offset by year-end can be deferred.

As described in Chapter 6, while this guideline is not specifically applied to not-for-profit organizations, it provides good guidance on interim reporting that not-for-profit organizations should follow.

Inventory Values in Business Combinations

In a business combination accounted for under the purchase method, inventories would be valued as follows:

1. Finished goods and merchandise: Estimated selling price less the sum of costs of disposal and a reasonable profit allowance.
2. Work in process: Estimated selling prices of finished goods less the sum of costs to complete, costs of disposal, and a reasonable profit allowance.
3. Raw materials: Current replacement costs.

In a business combination accounted for under the pooling-of-interests method, the recorded assets and liabilities of each entity generally are combined and become the recorded assets and liabilities of the combined entity. Thus, under the pooling-of-interests method, the recorded value of inventory should equal the combined book values of the combining entities' inventories.