Good business decisions can not be taken without knowing the company’s financial health. Hence, inventory valuation is important for businesses to accurately estimate the value of the goods they hold. It enables accurate financial reporting, informed decision-making, proper tax calculations, effective loan application, and strategic planning.
It ensures a clear picture of the company’s financial health, helps set competitive prices, and complies with accounting standards, which benefits both the business’s internal operations and external evaluation.
In this article, I have explained the concept of accounting policy for inventory valuation, its importance, and the methods used, and provide examples to illustrate these concepts.
Accounting Policies for Inventory Valuation
Companies must establish consistent accounting policies for inventory valuation to ensure accurate financial reporting and comparisons over time. It means the policy once employed can’t be changed frequently as it will result in suspicious accounting statements.
These policies are typically disclosed in the company’s financial statements along with the calculation formula. An accounting policy for inventory valuation should clearly state the chosen method (FIFO, LIFO, WAC, etc.) and any adjustments made, such as for obsolescence or lower cost or market (LCM) considerations.
AS 2 – Valuation of Inventories
Accounting Standard 2 (AS 2) provides guidelines for the valuation of inventories. It mandates that inventory should be valued at the lower of cost and net realizable value. Cost includes all expenditures incurred to bring the inventory to its present location and condition. Net realizable value is the estimated selling price minus any estimated costs to complete the product and make the sale.
Inventory valuation is a mandatory financial task to know the value of the inventory items a business holds on a particular date. Accurate inventory valuation is very important because it directly impacts key financial ratios such as gross profit, and net income mentioned in the company’s financial statements.
Proper inventory valuation ensures that a company’s financial reports accurately reflect its financial health and performance. To achieve this one of the most suitable inventory valuation methods is used by the accounting department of the business.
Here are the most common techniques used to evaluate inventory value,
Methods of Inventory Valuation
Most companies decide to use one of the following inventory valuation methods in their accounting policy. The decision to choose one of them is based on the company’s work scenario and the nature of the inventory items. Each of them has its own pros and cons.
1. First-In, First-Out (FIFO):
This method assumes that the oldest inventory is sold first. It is especially useful when inventory items have a limited shelf life, ensuring that older goods are sold before newer ones.
This results in COGS being calculated using the older, usually lower-cost inventory, leading to higher profits on the income statement. It is often favored during times of rising prices.
2. Last-In, First-Out (LIFO)
LIFO assumes that the newest inventory is sold first. This method is advantageous when prices are increasing, as it reflects the higher current costs in the COGS calculation, potentially lowering taxable income.
However, it might not accurately represent the physical flow of inventory and can lead to understated profits during inflationary periods.
3. Weighted Average Cost (WAC)
This method calculates the average cost of inventory items based on the total cost of goods available for sale divided by the total quantity.
It provides a balance between FIFO and LIFO, smoothing out cost fluctuations over time. It is simple to calculate and useful when inventory items are similar in nature and cost.
4. Specific Identification
Under this method, the actual cost of each individual item in inventory is tracked and matched with the corresponding sale. This is most suitable for businesses with unique or high-value items, but it can be administratively complex.
Let’s consider an example company: XYZ Electronics, to illustrate how different inventory valuation methods can impact financial reporting:
XYZ Electronics purchases smartphones at varying costs throughout the year. They start the year with no inventory and make the following purchases:
|Date||Quantity||Unit Cost ($)||Total Cost ($)|
Now we will calculate the inventory value and cost of goods sold (COGS) for the year using FIFO, LIFO, and Weighted Average (WAC) methods.
The first purchases from the months Jan and April are considered sold first.
COGS = (100 * $300) + (150 * $320) = $45,000
Ending Inventory Value = (120 * $310) + (80 * $330) = $45,600
The latest purchases from the months Aug and Nov are considered sold first.
COGS = (80 * $330) + (120 * $310) = $41,600
Ending Inventory Value = (150 * $320) + (100 * $300) = $53,000
Weighted Average (WAC):
All purchases to date are considered to calculate the total cost.
Total cost = $30,000 + $48,000 + $37,200 + $26,400 = $141,600
Total quantity = 100 + 150 + 120 + 80 = 450
Weighted Average Cost = $141,600 / 450 = $314.67
COGS = Weighted Average Cost * Goods Sold
Ending Inventory Value = Weighted Average Cost * Remaining Inventory
Best Inventory Valuation Method
The best inventory valuation method depends on the company’s specific scenario, industry, and external factors such as inflation rates. FIFO is generally considered the most straightforward and widely accepted method.
It results in a more accurate representation of the physical flow of goods and often aligns with real-world scenarios. However, for companies operating in industries with significant price fluctuations, weighted average cost (WAC) might provide a balanced approach.
Inventory valuation is not just a technical aspect of accounting; it’s a strategic decision that impacts a company’s financial health and decision-making. By understanding the different methods and their implications, businesses can make informed choices that lead to more accurate financial reporting and better insights into their operations.