Valuation of the inventory is an additional problem with which the ac-
countants must wrestle. The usual rule of valuation is “cost or market,
whichever is lower.” This rule gives a conservative value to the inventory.
Firms may now make a choice between the rule of first in, first out (FIFO)
and last in, first out (LIFO) as methods of inventory valuation. Under FIFO
(which most firms still use) it is considered (whether physically true or not)
that sales have been made of the older items, and that the items most re-
cently manufactured or purchased compose the inventory. Conversely, if
LIFO is used to value the inventory, then the new items coming in are con-
sidered to enter the cost of goods sold, and the cost of the older stock sets
the value of the inventory. Under the first method, FIFO, the value given
the inventory on the balance sheet is meaningful, but the cost of goods sold
figure used on the income statement may not truly represent current eco-
nomic costs if price levels have been changing rapidly. Under FIFO the ac-
counting figure for cost of goods sold tends to lag behind price level
changes, so that reported accounting profits are large on an upturn and de-
crease rapidly (or turn into reported losses) on a downturn in prices. By
contrast, LIFO reduces the lag in the accounting for cost of goods sold
when the price level changes, thus modifying the swing of reported ac-
counting profits during the trade cycle.
The LIFO method of inventory valuation, however, tends to develop
an inventory figure on the balance sheet that may not be at all representa-
tive of any current cost or price levels. The asset value of the inventory may
become more and more fictitious or meaningless as time passes. The reader
need only think of the inventory value of a 386 computer to IBM. More-
over, in defense of FIFO, any distortion it produces on the profit and loss
statement is not very great for firms that turn over their inventory rapidly
(i.e., for firms whose stock is replaced rapidly in relation to their sales).
Other current assets besides cash, receivables, and inventories are ac-
cruals, prepaid expenses, and temporary investments. Accrued items are
amounts that the firm has earned over the accounting period but which are
not yet collectible or legally due. For example, a firm may have earned inter-
est on a note receivable given to it in the past even though the note is not yet
due. The proportionate amount of interest earned on the note from the time
it was issued to the date of the balance sheet is called accrued interest, and
under modern accounting procedures is brought onto the books as an asset.
Prepaid expenses are amounts the company has paid in advance for
services still to be rendered. The company may have paid part of its rent in
advance or paid in on an advertising campaign yet to get under way. Until
the service is rendered the prepayment is properly considered an asset (i.e.,
something of value due the firm). When the service is rendered, the propor-
tionate share of the prepaid item is charged off as an expense.
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