6 Min. Read Show March 28, 2019 Inventory valuation is the monetary amount associated with the goods in the inventory at the end of an accounting period. The valuation is based on the costs incurred to acquire the inventory and get it ready for sale. Inventories are the largest current business assets. Inventory valuation allows you to evaluate your Cost of Goods Sold (COGS) and, ultimately, your profitability. The most widely used methods for valuation are FIFO (first-in, first-out), LIFO (last-in, first-out) and WAC (weighted average cost). What this article covers: NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area. What Are the Objectives of Inventory Valuation?Inventory refers to the goods meant for sale or unsold goods. In manufacturing, it includes raw materials, semi-finished and finished goods. Inventory valuation is done at the end of every financial year to calculate the cost of goods sold and the cost of the unsold inventory. This is crucial as the excess or shortage of inventory affects the production and profitability of a business. Determine the Gross IncomeInventory is used to find the gross profit, which is the excess of sales over cost of goods sold. To determine the gross profit or the trading profit, the cost of goods sold is matched with the revenue of the accounting period. Cost of goods sold = Opening stock + Purchases – Closing stock The above equation shows that the inventory value affects the cost and thereby the gross profit. For example, if the closing stock is overvalued, it will inflate the current year’s profit and reduce profits for subsequent years. Ascertain the Financial PositionClosing stock is shown as a current asset. The value of the closing stock on the Balance Sheet determines the financial position of the business. Overvaluation or undervaluation can give a misleading picture of the working capital position and the overall financial position. How Inventory Is ValuedThe method for valuing inventory depends on how the stock is tracked by the business over time. A business must value inventory at cost. Since inventory is constantly being sold and restocked and its price is continually changing, the business must make a cost flow assumption that it will use frequently. There are four accepted methods of inventory valuation.
Specific IdentificationUnder this method, every item in your inventory is tracked from the time it is stocked to when it is sold. It is usually used for large items that can be easily identified and have widely different features and costs associated with these features. The primary requirement of this method is that you should be able to track every item individually with RFID tag, stamped receipt date or a serial number. While this method introduces a high degree of accuracy to the valuation of inventory, it is restricted to valuing rare, high-value items for which such differentiation is needed. First-In, First-Out (FIFO)This method is based on the premise that the first inventory purchased is the first to be sold. The remaining assets in inventory are matched to the assets that are most recently purchased or produced. It is one of the most common methods of inventory valuation used by businesses as it is simple and easy to understand. During inflation, the FIFO method yields a higher value of the ending inventory, lower cost of goods sold, and a higher gross profit. Unfortunately, the FIFO model fails to present an accurate depiction of the costs when there is a rapid hike in prices. Also, unlike the LIFO method, it does not offer any tax advantages. Last-In, First-Out (LIFO)Under this inventory valuation method, the assumption is that the newer inventory is sold first while the older inventory remains in stock. This method is hardly used by businesses since the older inventories are rarely sold and gradually lose their value. This results in significant loss to the business. The only reason to use LIFO is when businesses expect the inventory cost to increase over time and lead to a price inflation. By moving high-cost inventories to cost of goods sold, the reported profit levels businesses can be lowered. This allows businesses to pay less tax. Weighted Average CostUnder the weighted average cost method, the weighted average is used to determine the amount that goes into the cost of goods sold and inventory. Weighted average cost per unit is calculated as follows: Weighted Average Cost Per Unit = Total Cost of Goods in Inventory / Total Units in Inventory This method is commonly used to determine a cost for units that are indistinguishable from one another and it is difficult to track the individual costs. Which Inventory Valuation Method Is BestChoosing the right inventory valuation method is important as it has a direct impact on the business’s profit margin. Your choice can lead to drastic differences in the cost of goods sold, net income and ending inventory. There are advantages and disadvantages of each method. For example, the LIFO method will give you the lowest profit because the last inventory items bought are usually the most expensive while the FIFO will give you the highest profit as the first items in stock are usually the cheapest. To assess the method which is best for you, you need to pay attention to changes in the inventory costs.
As a business owner, you need to analyze each method and apply the method that reflects the periodic income accurately and suits your specific business situation. The Financial Accounting Standards Board (FASB), in its Generally Accepted Accounting Procedures, allows both FIFO and LIFO accounting. It is also important to note businesses cannot switch from one method of inventory valuation to another. If your business decides to change to LIFO accounting from FIFO accounting, you must file Form 970 with the IRS. RELATED ARTICLES
Although every attempt is made to prepare and present financial data that are free from bias, accountants do employ a degree of conservatism. Conservatism dictates that accountants avoid overstatement of assets and income. Conversely, liabilities would tend to be presented at higher amounts in the face of uncertainty. This is not a hardened rule, just a general principle of measurement. In the case of inventory, a company may find itself holding inventory that has an uncertain future; meaning the company does not know if or when it will sell. Obsolescence, over supply, defects, major price declines, and similar problems can contribute to uncertainty about the “realization” (conversion to cash) for inventory items. Therefore, accountants evaluate inventory and employ lower of cost or net realizable value considerations. This simply means that if inventory is carried on the accounting records at greater than its net realizable value (NRV), a write-down from the recorded cost to the lower NRV would be made. In essence, the Inventory account would be credited, and a Loss for Decline in NRV would be the offsetting debit. This debit would be reported in the income statement as a charge against (reduction in) income.ApplicationNRV, in the context of inventory, is the estimated selling price in the normal course of business, less reasonably predictable costs of completion, disposal, and transportation. Obviously, these measurements can be somewhat subjective, and may require the exercise of judgment in their determination. It is also important to note that a company using LIFO or the retail method (as described in the next section of this chapter) would not use the lower-of-cost-or-NRV method, but would instead value inventory at lower of cost or “market.” Substitution of the word “market” entails subtle technical distinctions, the details of which are usually covered in more advanced accounting classes. It is noteworthy that the lower-of-cost-or-NRV adjustments can be made for each item in inventory, or for the aggregate of all the inventory. In the latter case, the good offsets the bad, and a write-down is only needed if the overall value is less than the overall cost. In any event, once a write-down is deemed necessary, the loss should be recognized in income and inventory should be reduced. Once reduced, the Inventory account becomes the new basis for valuation and reporting purposes going forward. Unlike international reporting standards, U.S. GAAP does not permit a write-up of write-downs reported in a prior year, even if the value of the inventory has recovered.
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