Accounting Principles and Inventories

Several accounting principles have special relevance to inventories. Among them are consistency, disclosure, materiality, and accounting conservatism.

Consistency Principle

The consistency principle states that businesses should use the same accounting methods and procedures from period to period. Consistency helps investors compare a company's financial statements from one period to the next.
Suppose you are analyzing a company's net income pattern over a two-year period. The company switched from LIFO to FIFO during that time. Its net income increased dramatically but only as a result of the change in inventory method. If you did not know of the change, you might believe that the company's income increased because of improved operations.
The consistency principle does not require that all companies within an industry use the same accounting method. Nor does it mean that a company may never change its methods. However, a company making an accounting change must disclose the effect of the change on net income. Sun Company, Inc., an oil company, disclosed the following in a note to its annual report:

Disclosure Principle

The disclosure principle holds that a company's financial statements should report enough information for outsiders to make knowledgeable decisions about the company. In short, the company should report relevant, reliable, and comparable information about its economic affairs. With respect to inventories, the disclosure principle means disclosing the method being used to value inventories. Suppose a banker is comparing two companies—one using LIFO and the other FIFO. The FIFO company reports higher net income, but only because it uses the FIFO inventory method. Without knowledge of the accounting methods the companies are using, the banker could loan money to the wrong business.

Materiality Concept

The materiality concept states that a company must perform strictly proper accounting only for items that are significant for the business's financial statements. Information is significant—or, in accounting terminology, material—when its presentation in the financial statements would cause someone to change a decision because of that information. Immaterial items justify less-than-perfect accounting. Their inclusion and proper presentation would not affect a statement user's decision. The materiality concept frees accountants from having to report every last item in strict accordance with GAAP.
How does a business decide where to draw the line between the material and the immaterial? This decision depends on how large the business is. Lucent Technologies, the maker of cordless phones, for example, has over $38 billion in assets. Management would likely treat as immaterial a $1,000 loss of inventory due to spoilage. A loss of this amount may be immaterial to Lucent's total assets and net income, so company accountants may not report the loss separately. Will this accounting treatment affect banker's or investor's decision about Lucent? Probably not. So it doesn't matter whether the loss is reported separately or simply embedded in cost of goods sold.

Accounting Conservatism

Conservatism in accounting means reporting items in the financial statements at amounts that lead to the most cautious immediate results. What advantage does conservatism give a business? Managers must be optimistic to be good leaders. This optimism sometimes causes them to look on the bright side of operations, and they may overstate a company's income and asset values. Many accountants regard conservatism as a counterbalance to managers' optimistic tendencies. The goal is for financial statements to present realistic figures.

• Conservatism appears in accounting guidelines such as
• "Anticipate no gains, but provide for all probable losses."
• "If in doubt, record an asset at the lowest reasonable amount and a liability at the highest reasonable amount."
• When there's a question, record an expense rather than an asset."

Conservatism directs accountants to decrease the accounting value of an asset if it appears unrealistically high. Assume that a company paid $35,000 for inventory that has become obsolete and whose current value is only $12,000. Conservatism dictates that the inventory be written down (that is, decreased) to $12,000.

Lower-of-Cost-or-Market Rule

The lower-of-cost-or-market rule (abbreviated as LCM) shows accounting conservatism in action. LCM requires that inventory be reported in the financial statements at whichever is lower—the inventory's historical cost or its market value. For inventories, market value generally means current replacement cost (that is, the cost to replace the inventory on hand). If the replacement cost of inventory falls below its historical cost, the business must write down the value of its goods. The business reports ending inventory at its LCM value on the balance sheet.
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