What is Inventory Valuation?
Accountants have two main options for inventory valuation: FIFO (First In First Out) and LIFO (Last In First Out). LIFO is only allowed under US GAAP and is a choice that US companies need to make. For this reason, FIFO is the more dominant valuation method internationally as it is permitted under IFRS.
FIFO assumes that the first goods in are the first to be sold. This means that ending inventory comprises the most recent purchases and therefore will reflect the most up to date costs.
LIFO assumes that the last goods in are the first to be sold, meaning stock turnover is the opposite to that of FIFO. Closing inventory is therefore valued at older costs.
Sometimes it is not always possible to know with accuracy the flow of stock in and out of the business; this is when a third approach to valuation, “weighted average”, might be used. This method will take the total cost of the goods and divide it by the total number of units within that accounting period. It gives a middle value between FIFO and LIFO value.
Key Learning Points
- Inventory valuation is important to help understand the value of unsold stock reported on a company’s balance sheet and reported profit in the balance sheet via Cost of Goods Sold (COGS)
- There are two common accounting methods used to value inventory: First In First Out (FIFO) and Last In Last Out (LIFO). Only FIFO is permitted under both IFRS and US GAAP.
- The different methods mean inventory value can incur large variances due to the impact of economic factors such as inflation
- LIFO liquidation is the process of companies quickly selling down their inventory balance without replacing the sold stock. This can have large impacts on the company’s reported profit due to “understating” the COGS amount. Companies are required to report large impacts due to LIFO liquidation in the financial footnotes sections of their the annual reports.
Inventory is a key line item in the balance sheet and affects the financial statements in several different ways. It matters which inventory cost is allocated into COGS as this directly affects reported profits. If reported profits are impacted by the expense incurred, then so is retained earnings and hence shareholders’ equity. Inventory will also affect working capital, therefore, valuing inventory correctly is crucial.
FIFO charges old units of stock to COGS and so this approach results in stock valuation at more recent prices. Therefore, FIFO produces a more accurate or relevant balance sheet.
LIFO charges new units to COGS, which means this approach produces a more realistic income statement. In an inflationary environment where we assume prices are rising and inventory is consistent or growing, then we expect to see the following impacts on each item:
How to Adjust a Company Reporting Under LIFO (US GAAP Only) to Make it Comparable with Companies Using FIFO?
In the US, companies using LIFO inventory accounting will always give you the value of their inventory using FIFO as well, so you can adjust to make their EBIT earnings number comparable.
Take Reliance Steel and Aluminium Inc. NYSE:RS. RS operates in an industry with highly variable prices of raw materials, so its choice of inventory accounting method will impact its profitability. RS’s inventory accounting policy is to use LIFO. They disclose the following in their accounts.
Inventory accounting note:
In 2018, RS reported EBIT of 974.5 (937.5 + 37 adding back the non-recurring impairment charge), using COGS of 8,253 and LIFO accounting. We can restate the EBIT level by doing a B-A-S-E analysis of the inventory accounting using the LIFO numbers to solve for purchase of inventory:
|Current Inventories (mostly LIFO)|
|Beginning inventory||1726.0||From the balance sheet|
|Purchases||8344.1||Reversed engineered from the other items|
|COGS||(8,253.0)||From the income statement|
|Ending inventory||1,817.0||From the balance sheet|
RS uses a combination of LIFO and FIFO inventory methods but mostly LIFO, however, we can still make the adjustment. Using the information in the note above, we can restate the B-A-S-E analysis using the FIFO ending balances, the inventory purchases, and solve for FIFO COGS:
|Beginning inventory||1747.8||From the balance sheet|
|Purchases||8344.1||From the LIFO BASE analysis|
|COGS||(7,981.2)||From the income statement|
|Ending inventory||2,110.7||From the balance sheet|
Note the beginning and ending balances add both FIFO inventory lines (21.8m in 2017 and 293.6m in 2018).
So, if the company used FIFO inventory accounting its COGS would be 7,981.20 rather than 8,253 – a difference of US$271.80MM, and its EBIT number would be US$1,246.3MM a material difference. In trading comparables, analysts would use the FIFO number as it’s comparable to the international peer group.
You might have noticed a faster, but less intuitive way of making the adjustment, is just to take the change in the LIFO reserve – also noted in the inventory note. The LIFO reserve is the accumulated difference between LIFO and FIFO inventory accounting.
A final issue is where companies who use LIFO inventory accounting start to sell down their inventory and stop replacing sold products. LIFO accounting always takes the most recent purchases as COGS, but if you stop purchasing new inventory you will begin to account for COGS using older and older ‘layers’ of inventory. In some situations, the ‘liquidation’ of inventory can result in extremely old inventory prices, which due to inflation can dramatically understate the current cost of inventory in COGS, and suddenly higher profits. In the inventory note above, the company states any liquidation of LIFO inventory layers is insignificant.
A good example of a LIFO liquidation is RYI in 2007. In RYI’s 10-K they noted:
The period from January 1 to October 19, 2007 includes a LIFO liquidation gain of $69.5million, of $42.3 million after-tax. The year ended December 31, 2008 includes a LIFO liquidation gain of $15.6 million, or $9.9 million after-tax.
RYI’s 2007 operating profit was $US161MM flattered by a LIFO liquidation gain of US$69.5MM.