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What is inventory valuation, and why is it important?

Posted by Shivali Anand

April 20, 2022    |     7-minute read (1388 words)

Inventory valuation is the accounting process of assigning value to a company's inventory at the end of a reporting period. When it comes to accounting for business inventory, the valuation method you apply will directly influence the assets shown on your business's balance sheet and the cost of goods sold shown on its income statement. 

To ensure your company's bottom line isn't hurt by miscalculated inventory costs, you need to record the correct amount on your financial statements. Analyzing the four basic inventory valuation methods allows you to choose which one is the most beneficial for your business.

What does inventory refer to?

Inventory includes everything that goes into making or selling physical goods, such as raw, work-in-progress and finished goods, for a business that makes or sells tangible commodities. For example, consider a company that manufactures greeting cards and sends them to merchants to sell. Before they can put 100 greeting cards in a box, the business first has to make them. Aside from the finished cards and the paper with which they are made, the company’s inventory includes cardboard packaging boxes it uses to send the cards to retailers.

If the firm creates its own packaging, then its inventory also comprises the unassembled printed cardboard and the glue required to construct the boxes. Manufacturing the packaging is a multistep procedure, so the firm may have stacks of half-finished greeting card packages lying around. These items also belong to the business’s inventory.

Why is inventory valuation important for businesses?

Inventory is the greatest current asset of a trade or manufacturing firm and may account for the largest part of its total assets. Inventory is commonly acknowledged as a crucial asset affecting operational efficiency. Whether a manufacturing, trade or service firm, excess or lack of inventory negatively impacts productivity and profitability. Further, incorrect inventory investment and valuation undermine the firm's liquidity and cash flow management

The cost of goods sold, gross income and the monetary worth of inventory left at the end of each accounting period are affected by how a firm values its inventory. Consequently, inventory valuation impacts a company's profitability and future valuation, as indicated in its financial statements.

Once a business has selected an inventory valuation method, it must continue using that method. The IRS’ Publication 334 states: “The method you use to value your inventory must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent from year to year.”

Inventory valuation affects a business’s financial position in terms of:

Impact on COGS: A higher inventory valuation leaves less expense to be charged to the cost of goods sold, and vice versa, affecting profits reported. 

Multi-period impact: An inaccurate inventory valuation will result in incorrectly reported profits in two consecutive periods. The erroneous ending balance in the first period carries over into the beginning inventory balance in the second reporting period.

Loan ratio:  A lender’s business loan agreement may limit the acceptable ratio of current assets to current liabilities. Not meeting the stipulated ratio could lead to the loan’s cancellation or penalties. As the largest component of the assets to liability ratio, inventory valuation is crucial.

Tax implications: The last-in, first-out (LIFO) inventory valuation method, frequently used to lower income taxes paid during periods of rising prices, can affect the amount of tax liability.

Challenges of inventory valuation

If your business necessitates the holding of inventory, you should be aware of the accounting challenges that can arise from having products on hand, such as: 

Acquisition expenses – Goods don't just appear in your stockroom with a fee attached. You can either manufacture or buy those products. If you make them, you must account for the price of raw materials, direct labor and factory overhead. You must include them in both the wholesale price, freight and handling if you purchase them. In both cases, costs must be attributed to specific objects so they can be deducted from sales proceeds.

Accurate valuation – Generally, your inventory is valued “at cost,” reflecting the expenditures incurred to manufacture or acquire it. But as every businessperson knows, occasionally you end up with stock that isn't worth what you bought for it. Products may get damaged, go out of style and become outdated, and industry price drops might compel you to set prices below cost. For these reasons, accountants need inventory to be appraised at “cost or market.” The item's worth on the balance sheet is either the purchase price or the sale price, whichever is lower.

Perpetual versus periodic – To generate accurate financial accounts, you must know how much inventory you have. Businesses record inventory in one of two ways: periodic or perpetual. A periodic system estimates inventory on a regular basis. It subtracts the cost of things sold out of inventory since the start of the period and adds the cost of inventory purchased. A perpetual inventory system works by updating inventory counts continually as goods are bought and sold.Modern inventory-tracking software enables the ongoing updating of inventory’s value more simply than in the past. Both inventory methods require regular physical inventories to assess losses due to breakage, damage or theft.

Methods of cost – Costs fluctuate, meaning the cost to acquire an item now may not be the same tomorrow. As a result, companies require a way to manage inventory expenses. The first-in, first-out (FIFO), last-in, first-out (LIFO) and weighted average are the most popular ways to calculate COGS and ending inventory.

Inventory valuation objectives

The objectives of inventory valuation include:

1. Determining trading profit: Inventory is a component in calculating gross profit or trading profit. Gross profit is the sales less the cost of items sold.

2. Determining financial status: Inventory plays an important role in determining a company's financial position. The closing inventory is reported as a current asset on the balance sheet. Inventory valuations that are too high or too low create a false impression of the company's working capital and overall financial position.

3. Calculating actual income: The matching principle requires that companies report expenses at the same time as the revenues they are related to. In other words, the cost incurred during the manufacturing or procurement of inventory is charged to the income statement of the accounting period in which the inventory was sold. Any inventory left unsold at the end of the accounting period is excluded from the computation of cost of goods sold.

Deciding on the appropriate inventory valuation method

To perform an inventory valuation, you must adopt and consistently apply a cost-flow assumption describing how inventory moves through the business. Cost-flow examples are included below. Whichever technique is used, the inventory value at the conclusion of the reporting period will be affected.

Method of specific identification: The specific identification method tracks individual inventory items' costs. It is most frequently used when each item in the inventory is unique, such as in an art gallery.

Method of first-in, first-out (FIFO): The FIFO method is applied where the first assets produced are sold first. This implies that the oldest products in the inventory records are initially charged to the cost of goods sold. As a result, during periods of price inflation, the cost of products supplied are low, resulting in higher reported profits and increased income taxes.

Method of last-inn, first-out (LIFO): The LIFO method is applied where the last thing added to the inventory is the first item sold. This suggests that the most out-of-date things are kept in stock, which is highly improbable. However, this method is widely used since it adds the most current expenses to the cost of items sold. In an inflationary environment, this tends to lower earnings and hence the amount of income tax liability.

Method of weighted average: This method uses a weighted average to determine the amount of money that goes into COGS and inventory. This ensures that the cost of products sold is neither extremely high nor excessively low during a period of price inflation, making it simpler to track and calculate inventory value.

Conclusion

As an entrepreneur, you should know about inventory valuation as it can be a significant asset on your balance sheet. Applying the best valuation method can help you achieve your goals for business growth and help you take advantage of existing market conditions. 

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