Cost Flow vs Valuation: Inventory Accounting

Posted in CFA by qmarks on April 2, 2010

Merchandising firms such as wholesalers and retailers purchase inventory that is ready for sale, i.e. WalMart, Loblaw, Metro buys the finished good and keeps them in their inventories until they replace it to shelves. On the other hand, manufacturing firms such as Ford outsources their body parts from Magna International. For Magna, they can buy steel as raw good, keep them in warehouses, make body parts using the steel, and eventually ship the produced body parts to the Ford. During that process, Magna reports inventory using three separate accounts: raw materials, work-in-process and finished goods.

The choice of inventory cost flow method affects the firm’s income statement balance sheet and several important financial ratios. Additionally, the cost flow method can affect the firm’s income taxes and thus the firm’s cash flow.

Generally inventory is reported on the balance sheet at cost and a writedown (loss) is recognized if the market value of inventory declines below cost.

The valuation method (lower of cost or net realizable value for firms reporting under IFRS, and lower of cost or market for firms reporting under US GAAP) is applied regardless of the cost flow method.


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