Meaning Of Inventory Valuation
An inventory is the amount of stock of raw materials, intermediates, and finished goods available for sale in the market to earn a maximum profit. To ensure accurate usage and availability of all materials, it is necessary that inventory be valued, whether it’s unsold stock in the godown or total input material purchased. Inventory valuation is an accounting practice to find the amount of closing stock at the end of the financial year left with the company or the manufacturer. Inventory valuation is an asset for the company, and therefore it needs to have a financial value to be recorded on the balance sheet. An inventory valuation allows a company to provide monetary value to the items in its inventory.
This ensures accurate financial statement results, as inventories are the largest asset for any business that deals either in manufacturing or providing products. Business inventories consist of all the supplies which are required to operate the business effectively, either required for self-utilization or for sale in the market to the consumers. For example, a furniture shop would consider furniture as an inventory, whereas a bakery would have sugar, and wheat as raw materials. Inventory holding is costly as storage costs require valuing the inventory at optimal cost. In this case, the handling of clothes in requires an additional warehouse to accommodate the optimal level of inventory, which could have been an unavoidable cost and can be operated safely with the minimum level of inventory in the present stock at the time of valuation.
Inventories depreciate with time, which means they are losing their value due to wear and tear, especially in organizations that deal with advancements and continual changes with respect to the change in the demands in the market. For example, a television seller will be willing to sell its products at the earliest when the advancement in technology will outdate its products and unsold stock will not be in demand anymore with the coming of LED and Plasma. As the obsolete settles in, the business will be required to sell the existing product at a discount, thereby creating space for the newer and technology-driven product.
Significance Of Inventory Valuation
Inventory generally refers to the stock in trade with the company, which generally includes raw materials, semi – finished goods, finished goods, and products also called spare parts. The inventory stated at the beginning of the year is termed as opening inventory and the inventory perishing at the end is counted as the closing inventory. But just counting the inventory is of no use unless it is being valued. The valuation of inventory is necessary and the process of valuation helps in determining the value at which the stock will be recorded in the financial statements of the company.
The valuation of inventory represents the true and fair position of the trading results of the concern, its profit and loss can be accurately ascertained, as well as the position of the entity at the year-end can be easily accessed. The valuation shows a fair representation of the finances of the company. There are numerous reasons why inventory valuation is so significant for any concern to operate effectively.
Helps determine income
The perfect and accurate method to calculate gross profit and loss and ascertain net profit and loss is one of the most significant reasons for doing valuation. For a particular year, the cost of goods is made to be matched with the direct revenue of that particular accounting period. The cost of goods is calculated by the formula –
COGS = opening inventory + net purchases made (purchase – purchase returns) + any direct expenses – closing inventory
The valuation of inventory will have a direct impact on income determination, depending upon the valuations made stating whether overstated or understated, which can be explained as-
- If closing inventory exceeds the opening inventory, the net income for the accounting period will be overstated.
- If the opening inventory exceeds the closing inventory, the net income for that particular accounting period will be understated.
- If closing inventory is understated, the net income for the accounting period will be understated.
- If an opening inventory is understated, the net income for that particular accounting period will be overstated.
Hence, one can conclude that the inventory evaluation (closing inventory) has a direct impact on the determination of the income of an entity. Any miscalculations or misstatements during inventory evaluation can result in overstated or understated profits for the firm.
Valuation of inventory is not statutory compliance under the Companies Act 2013. In compliance with the accounting standard (AS 2), each and every firm is required to disclose the inventory valuation of each class, which states inventory should be either the net realizable value (NRV) or the value at cost, whichever is lower than the other one. The disclosure must include-
- The accounting policies adopted by the entity for inventory valuation.
- The total amount of inventories left along with their classifications i.e. raw materials, WIP (work in progress), end goods, etc.
Helps determine financial position
Inventory not only forms part of the profit and loss statement but also is an essential part of the balance sheet. Inventories are considered as the current assets of the firm. Hence, it is essential to have an accurate and true valuation of inventory. If the inventory value is calculated incorrectly, it will result in a misleading representation of the financial position on the date of the balance sheet.
Inventory being the current asset, the firm cannot hold such inventory for a longer period of time, there is a lot of turns when it comes to stock. Therefore, inventory comprises a significant part of the working capital of a firm. Thus, it is imperative to correctly value it so that the quick ratio and other liquid ratios can be precisely calculated. These ratios are important to compare and analyze the liquidity of a company.
Inventory Record System
An inventory recording system is the hub of the inventory operations, with which the other systems bidirectionally connect. This states that inventory information assessment can be done from the system of record or some other system, but the data will always be up to date. An inventory recording system deals with the recording of physical quantities of stocks and their valuation. There are two basic systems for determining the inventory of a firm. These are –
- The perpetual inventory system
- The periodic inventory system
Perpetual inventory system
The perpetual inventory system is a system that is defined as a system of records that are maintained by the controlling department, which thus reflects the physical movement of stocks and also their current balance. It is a system of ascertaining balance after every receipt of materials and their issue through stock records to facilitate their regular checking and to avoid the firm’s closing down for stock taking. The bin card and the store ledger are used to ensure the accuracy of the perpetual inventory records and physical stock verification is being done by a program of continuous stock-taking.
The working of the perpetual inventory system is as follows –
- The stock records are maintained up to date, and a posting of transactions is made so that the current balances can be known at any time.
- Different sections in the stores are taken up rotationally for physical checking. Every next day some items are checked, so that each and every item is checked frequently during the year.
- Stores received but awaiting quality inspection are not mixed with the regular physically verified stocks, as the entries persisting to such stores still do not form part of the stock records.
- The physical stock that is presented in the store, after weighing, measuring, counting, and listing is recorded in the bin card or inventory tags or stock verification sheets.
The perpetual inventory system is different from continuous stock-taking, which is the most essential feature of the perpetual inventory system. Perpetual inventory means the system of stock records and continuous stock taking, whereas continuous stock taking means only the physical verification of the stock records with actual stocks.
Continuous stock-taking includes physical verification spread throughout the year. Randomly, ten to fifteen items are chosen rotationally and checked to remove the surprise element in stock verification, and each item is checked a number of times each year. Controversially, the surprise element is missing in the case of periodical checking, as the checking is usually done at the year’s end.
Advantages of perpetual inventory system
- A reliable and detailed check on the store is maintained. The level of various items in stores is recorded and made available, which facilitates the work of procurement for stores.
- Errors disintegrate, irregularities, and stock losses through various methods are removed, and necessary actions are taken to avoid the recurrence of such errors in the future is minimized.
- Systematically, the work is being carried out and the figures are made available without any hassle.
- A comparison between actual stock can be made with the maximum and minimum stock levels, thereby ensuring the optimal level of stock. The disadvantages of surplus stocks are avoided and capitalized up in stores material that cannot exceed the budget.
- The financial statements like profit and loss accounts and the balance sheet are prepared monthly or quarterly, the stock data is presented accurately and there is no mandate for physical verification of the balances.
- The perpetual inventory system obviates the requirement for the physical checking of all the items in stock and the store at the end of the financial year.
- It avoids the dislocation of the routine activities of the entity, which include production, dispatch, packing, etc.
Periodical stock verification
This system envisages physical stock verification at a fixed date or period during a particular year. Generally, this system checks the activity at the end of the accounting period or the closure of accounts up to the date. The system is followed in the manner prescribed –
- A period of 5 to 7 days is taken depending on the frequency of the work chosen in which all the items in the stock are physically verified. Such a period of 527 days is regarded as a cut off period. During this period, no movement of stock items takes place i.e. neither the receipts nor the issues are permitted.
- Each and every item is physically counted and measured depending upon the nature of the item and is recorded in the records after being signed by the auditors present during the stock verification.
- The auditors also audit the bin card balances. The physical balances should reconcile with the bin card entries unless there is a shortage or excess or there is a human error in recording or balancing the cards.
- The completed worksheets are counter-signed by the godown supervisors and the stock is verified after the physical verification.
- Thereafter, the reconciliation statement is prepared item-wise for the physical balances and the bin card balances, if these balances are different.
- Thereafter, the bin card balances and store ledger are also compared, and necessary adjustments are made to show the true and correct positions of the stock at the end of the year.
- Finally, the shortages and excess statements are prepared by the departments concerned and thereby placed before the top management for their approval adjustments.
Advantages Of Periodic Inventory
- The major advantage of the periodic inventory system is that the inventory is counted only at specific intervals and not randomly.
- There is no need to monitor the inventory level between review periods. The system works best when the order includes several different items from a supplier.
- A periodic inventory system has the ability to track both the purchases and sales over a specific period.
- A periodic inventory system determines the cost of goods sold by adding merchandise purchase cost, opening inventory cost, and deducting the closing inventory cost.
- Although periodic inventories are a cheaper process, conducting the same for a large business might prove to be an arduous task as it is time-consuming and requires a lot of dedicated manpower. A perpetual inventory system, on the other hand, is not only more expensive but also faster.
- One of the biggest benefits of the periodic system is its ease of implementation, as it is less stressful for maintaining an awareness of inventory.
- This system is best suitable for small businesses, mostly one to two people, with limited inventory and a dozen orders placed throughout the year.
Methods Of Inventory Valuation
Inventory valuation methods refer to the methodology used for the valuation of the company and the methods used to value such inventory are FIFO – First In First Out, LIFO- Last In First Out, WAC- Weighted average method that has an influential impact on the cost of goods sold as well as the ending as the inventory and thereby impacting the financial bottom-line numbers and the cash flow situation of the company.
FIFO inventory stands for the first in, first out. It is the method of pricing the materials in the order in which they are purchased. In other words, the materials are issued on the basis of their arrival in the store. The ideal method is in the case of falling prices, as the material cost charged to production will be high while the replacement cost of material will be low. This method is not suitable in the case of rising prices. Goods produced should be sold first, and this order should be followed in which the cost of goods sold and inventory should be calculated.
Consider a case of a shoe manufacturer who buys soles for the shoe through 2 transactions-
- 500 sole at Rs. 25 each
- 300 sole at rs.30 each
Also assume that there are 400 soles sold at the end of the month.
|Cost of goods sold
Cost of goods sold = 400 * 25
Remaining inventory = 100 (500- 400) * 25 +300* 30
= 2500 +9000
- First in, first out is the easiest and the most intuitive of all the methods. This method is by default applied in small outlets and retail shops without even knowing about the mechanism involved in such a process.
- Because the process is simple and cannot be easily manipulated, there is less chance of confusion.
- Most often, the price calculated matches with the actual cost involved, as the FIFO prices inventory in the order in which it was purchased.
- The cost of the product matches the actual cash flows and the physical flow of goods across the warehouse.
- Purchases made at the end of the period do not affect the revenue as the input cost is calculated on the basis of the order in which it was being produced.
- It is not necessary that prices increase proportionately with the increase in time. The prices rise to a small extent when compared with the change in time. This leads to a mismatch between the costs and the revenues when FIFO is applied because the paper calculations do not just justify the actual inflated calculations.
- Even with normal inflation, there is a greater tax burden as the profits look inflated as compared to other methods. No accounting rules can help the organization as it is difficult to manipulate.
LIFO inventory stands for Last in First Out and is the opposite of FIFO. It states that the goods purchased last, should be sold first and the goods purchased first should be sold last. In this method, the prices of the last received batches (lot) are used for pricing the issues, until they get exhausted. Using the LIFO method during an inflationary or rising-price period would help to ensure that production costs are determined roughly on a current basis.In LIFO, stocks are valued under old prices and do not represent the current prices.
|Cost of goods sold
Cost of goods sold = 300 * 30 + 100 * 25
= 9000 + 2500
Remaining inventory = 400 * 25
- The biggest advantage of the LIFO method is that it matches the profitability in a better way. The net income which is calculated is less and the profits that are attained are also less.
- Accountants and regulators believe that it aids in gauging the management ability of profit generation.
- This method is far better than the LIFO method, as it has huge paper profits compared to the actual ones.
- LIFO uses the current cost for the calculation of the cost of goods sold, which cannot be manipulated by inflation.
- There is less burden of taxes on the bottom line because of the latest price consideration.
- LIFO method is difficult to implement as it involves the piling up of old inventory and the selling up of new inventory which can be dangerous for perishable and leads to wastage, which increases the costs and decreases the revenue.
- US GAAP and many accounting regulators consider this method risky and do not approve the LIFO method for inventory valuation.
It is believed that determining the value of the inventory is necessary for every company that sells physical goods for accounting purposes. The manner in which inventory is valued affects a large number of assets of the business, so the manner in which it is valued can affect the company’s tax liability, profits, and asset value significantly.
From the various inventory methods present, it is important for companies to choose one of them that best suits their business.
The impact that the inventory valuation has on the financial numbers justifies its importance in the firm. It is advised that proper analysis and diligence must be done before the selection and implementation of the valuation method, as once the method gets started, we cannot change it in between.