The general answer is that inventories should be reported at cost. A merchant’s inventory would be reported at the merchant’s cost to purchase the items. A manufacturer’s inventory would be at its cost to produce the items (the cost of direct materials, direct labor, and manufacturing overhead).

The conservatism principle requires that an amount less than cost be used when the replacement cost is less than the original cost. When this is the case, the selling price minus the cost to complete and dispose might be the amount to be reported. (The selling price minus the cost to complete and dispose is the net realizable value.) In a few industries, such as gold mining and meatpacking, it is accepted practice to report the inventory at its net realizable value.

Since the unit cost of items in inventory is likely to be changing (think inflation), the costs used for inventory reporting will be based on a cost flow assumption. For example, the FIFO cost flow assumption will result in the inventory being reported at the more recent costs, since the first costs are assumed to have been the first costs out of inventory. Under the LIFO cost flow assumption, the inventory will be valued at the older costs, since the more recent costs are assumed to be the first costs to flow out of inventory.

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About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the creator of the AccountingCoach Pro which has been praised for its ability to simplify accounting in a way that anybody can understand.

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