LIFO basis of inventory valuation for retail business - is it justified?
Inventories are the assets which are held for:
Sale in the ordinary course of business like finished goodsThere are certain items which are outside the purview of regular inventory like investments in stocks, long term construction contracts.
Used in the process of production like Raw materials, Work in process
Rendering services to customers like Stores and spare parts.
The measurement principle followed for inventory is lower of Cost or Net realizable value.
Cost is best determined by "Specific Identification method" which is very difficult to monitor when inventory involves huge numbers of similar nature items.
Consequently Indian GAAP (IGAAP) - AS 2 recommends First-in First-out (FIFO) or weighted average method. Also Standard cost can be adopted where standard costs match the actual cost.
However for retail business, where the large number of inventories keep on changing frequently, "retail price method or adjusted selling price method" is suggested where in selling price less gross profit is deducted to arrive at the value of closing inventory.
Treatment in IFRS- IAS 2 is also similar to AS2 of I-GAAP not permitting Last-in, First-out (LIFO) as it rarely reflects the actual physical inventory flow.
However, US GAAP allows LIFO which presumes that recent purchases are consumed first and hence inventory on hand consists of earliest purchases.
Let's take a look at the accounting policies of Wal-Mart Stores, Inc. which is engaged in the operation of retail, wholesale and other units in various formats around the world. Walmart has 11, 000 stores in 27 countries and e-commerce websites in 11 countries. Walmart follows EDLP- everyday low price with broad assortments and control expenses with EDLC- everyday low cost strategy.
As of Jan 2015, the inventory at Wal-Mart was USD 45,141m ( around 25% of total assets ) valued at lower of cost or market using LIFO method for US operations (allowed by US GAAP) and for Walmart international segment FIFO method for valuation of inventory as per IFRS is used.
Wal-Mart is fully justified in adopting LIFO basis of inventory valuation as we tend to pick the latest arrival when we visit a mega mart. For e.g. If two consignments of chocolates are available, both within the shelf life, we still pick a consignment which will have longer shelf life. So typically, latest consignment is cleared first and finally the retailer is forced to come out with a scheme of "buy one and get one free" so as to ensure that the old consignment is somehow disposed of to minimize the losses.
Going by this logic, for retail business, LIFO method should be allowed even by IFRS which represents the actual movement of the inventory. However, one should carefully consider merits and demerits before adopting LIFO basis of inventory valuation.