What is Inventory Valuation, and Why is it Important?

Inventory valuation is an accounting process businesses use to determine the value of unsold inventory items when generating their financial accounts. Inventory makes up a significant amount of the assets of any firm that sells tangible goods, and therefore it’s critical to keep track of its value. A deep understanding of inventory valuation can aid in maximising profits, and it also assures that its inventory value is appropriately represented in its financial accounts.

Businesses can use this amount to calculate their inventory turnover ratio, which can help you plan your purchases. The accounting treatment for inventories is provided by Ind AS-2 and AS-2, particularly in terms of their measurement and disclosure. The technique used to value inventories can impact a company’s gross profit within a given accounting period.

Did you know?

Inventory valuation directly impacts COGS, i.e. Cost of Goods Sold and is an important factor in measuring your company’s overall financial health.

Also Read: Everything You Need to Know about Inventory Costing Methods

What is Inventory Valuation?

The monetary amount associated with the goods in inventory at the end of an accounting period is known as inventory valuation. The price is determined by the costs of acquiring the goods and preparing it for sale.

The largest current business assets are inventories. Inventory valuation helps you assess your cost of goods sold (COGS) and, as a result, your profitability. FIFO (first-in, first-out), LIFO (last-in, first-out), and WAC are the most commonly utilised valuation methodologies (weighted average cost).

Why is Inventory Valuation Important?

Inventory valuation provides precise metrics utilised to make strategic decisions and prepare accurate financial accounts. Following a thorough inventory assessment, a more informed decision can be taken on many firm parts.

The list given below includes all the reasons why the valuation of the inventory is advisable for every business:-

Impact on COGS

There is much less expensive to charge the Cost of Products Sold when closing inventory has a higher valuation and vice versa. As a result, the profit levels stated are heavily influenced by inventory valuation.

Impact on Ratios Relevant to Loan Finance

If a business has obtained a loan from a lender, the loan agreement may restrict the allowable proportions of current assets to current liabilities. If the entity fails to meet the target ratio, the lender can call the loan. Because inventory is often a large component of this current ratio, inventory valuation is critical.

Impact on Income Taxes

The cost-flow technique utilised can affect the amount of taxes paid. During heightened prices, the LIFO technique is often employed to reduce the income taxes paid.

Impact on Multiple Periods

Because the incorrect ending balance in the first period will be incorrect, it will carry over into the beginning inventory balance in the next reporting period, causing the reported profits in two consecutive quarters to be incorrect.

Objectives of Inventory Valuation

The ultimate purpose of inventory valuation is to assist in the formulation of an accurate picture of a firm’s total profit and financial situation. The gross profit of a corporation is determined by deducting the Cost of Goods Sold (COGS) from net sales (total sales, fewer returns and discounts, and any other income not related to sales).

How a company assesses its inventory directly affects its gross profit and income statement, which banks and investors use to evaluate financial performance. The value of inventory impacts a company’s balance sheet, which reflects the company’s assets and liabilities. Inventory, together with cash, short-term investments, accounts receivable, supplies and prepaid insurance, is considered a current asset for accounting purposes.

Different Inventory Valuation Methods

The inventory valuation technique is a method for calculating the overall value of a company’s inventory at any given time. The inventory value is computed using the total cost of purchasing and preparing the inventory for sale. This is critical in accounting because the valuation of any item is used to calculate the Cost of Goods Sold, which directly impacts the income statement and balance sheet.

The most popular methods of inventory valuation are as follows:- 

1. First-In, First-Out (FIFO)

According to the First-In-First-Out (FIFO) value strategy, inventory products are sold in the same order as purchased or manufactured. The oldest inventory products are sold first, according to the FIFO principle. The FIFO value method is the most often used inventory valuation method since most companies sell their products in the same order that they buy them. There are two fundamental drawbacks of FIFO. For starters, a larger gross income means a higher tax burden. Second, FIFO can lead to financial statements that are misleading to investors during periods of strong inflation.

2. Last In, First-Out (LIFO)

This inventory valuation approach is the opposite of the First-In-First-Out (FIFO) inventory valuation method. It is assumed that the products purchased or manufactured most recently are sold first. LIFO allows for a more precise match between expenses and revenue. It also lowers the company’s tax bill while increasing COGS.

3. Weighted Average Cost (WAC)

Inventory and Cost of Goods Sold (COGS) are determined using the Weighted Average Cost inventory valuation method, which uses the average cost of all things purchased over a period. This strategy is primarily employed by businesses that do not have inventory variances.

Also Read: Learn About Safety Stocks

Examples of the above 3 methods of inventory valuation

Now the value of purchases is ₹23,750 (100*20 200*30 350*45)

The value of inventory under the three methods will be as follows:-

1. FIFO – Items bought will be sold first. The value of sales will be ₹10,250 (100*20 200*30 50*45). Now the closing stock will be ₹23,750 – ₹10,250 = ₹13,500.
2. LIFO – Items bought will be sold first. The value of sales will be ₹15,750 (350*45). Therefore, the closing stock will be ₹23,750 – ₹15,750 = ₹8,000.
3. Weighted Average Cost – The total value of purchases is divided by the total number of units to get the average cost.

Average Cost = ₹23,750/500 = ₹47.5

Sales = 350*47.5 = ₹16,625

Closing Stock = ₹23,750 – ₹16,625 = ₹7,125.

Choosing the Right Inventory Valuation Method

There are no hard rules for which valuation method is best for a particular business, but let’s look at the advantages and disadvantages of each method:

• At the moment, FIFO yields the grossest income, LIFO the least, and WAC somewhere in the centre.

This is based on a standard inflationary scenario in which supplier costs rise over time.

As a result, FIFO has the highest tax burden, while LIFO has the lowest, with WAC in the middle.

• LIFO is permissible under the US Generally Accepted Accounting Principles (GAAP) but not by International Financial Reporting Standards (IFRS) (IFRS).

As a result, while LIFO is available in the United States, it is not in many other countries.

LIFO can match current income with recent costs, reducing the effects of inflation and deflation.

• The apparent solution is to use a specific ID when you, your shareholders or your clients want to know the cost and the selling price of each unit.

People who purchase and sell art may be interested in how the price of a Rembrandt changed from when it was last purchased to when it was sold.

Challenges of Inventory Valuation

When valuing inventory, there are two primary challenges: the company must estimate the overall cost of its inventory, and to do so, it must first figure out how much inventory it has, which can be difficult.

Keep Track of Your Inventory Costs

The following is the basic equation for calculating the value of your remaining inventory at the end of an accounting period:

COGS = Opening Stock Purchases – Closing Stock.

Now,

Closing Stock = Opening Stock Purchases – COGS.

The importance of beginning and ending inventory, on the other hand, may not be as straightforward as it appears. Anything you can’t sell for full price due to damage, obsolescence or simply shifting consumer tastes needs to be marked down and valued properly.

Determining the Amount of Inventory

This can also be more difficult than it may seem, and it may also be necessary to undertake physical inventory counts. A periodic inventory system is used by many businesses to keep track of goods, and companies use this technique to evaluate inventories after each accounting period. On the other hand, a perpetual inventory system tracks every purchase order and sale and changes inventory to reflect those activities constantly.

Conclusion

The Cost of Goods Sold (COGS), gross income and the monetary worth of inventory remaining at the end of each period are affected by how a company values its inventory. As a result, inventory valuation impacts a company’s profitability and future value, as shown in its financial accounts.

It’s also crucial to choose an inventory valuation method since once a corporation has decided, it should generally stay to it.
Follow Legal Tree for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.